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Understanding Capital Markets
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Understanding Capital Markets, Structure and Function
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This checklist outlines capital markets, their structure, and their function.
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Definition
Capital markets provide a wide range of products and services that are related to financial investments. Capital markets
include the stock market, commodities exchanges, the bond market, and just about any physical or virtual service or
intermediary where debt and equity securities can be bought or sold. Their primary purpose is to raise funds and channel
investors’ money to areas where there is a deficit or need for investment. They play a vital role as intermediaries between
governments and companies, which use them to finance a myriad of activities.
The capital markets can be broken down into the primary market, where new stocks and bonds are issued to investors, and
the secondary market, where existing stocks and bonds are traded.
In the primary market, governments, companies, or public sector organizations can obtain funding through the sale of a new
stock or bonds. These are normally issued through securities dealers and banks, which underwrite the offered stocks or
bonds. The issuers earn a commission, which is built into the price of the security offering.
In the secondary market, stocks and shares in publicly traded companies are bought and sold through one of the major
stock exchanges, which serve as managed auctions for stock. A stock exchange, share market, or bourse is a company,
corporation, or mutual organization that provides facilities for stockbrokers and traders to trade stocks and other securities.
Stock exchanges also provide facilities for the issue and redemption of securities, trading in other financial instruments, and
the payment of income and dividends.
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Advantages
Capital markets provide the lubricant between investors and those needing to raise capital.
Capital markets create price transparency and liquidity. They provide a safe platform for a wide range of investors
—including commercial and investment banks, insurance companies, pension funds, mutual funds, and retail investors—to
hedge and speculate.
Holding different shares or bonds allows an investor to spread investment risk.
The secondary market gives important pricing information that permits efficient use of limited capital.
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Disadvantages
In capital markets, bond prices are influenced by economic data such as employment, income growth/decline,
consumer prices, and industrial prices. Any information that implies rising inflation will weaken bond prices, as inflation
reduces the income from a bond.
Prices for shares in capital markets can be very volatile. Their value depends on a number of external factors over
which the investor has no control.
Different shares can have different levels of liquidity, i.e. demand from buyers and sellers.
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Action Checklist
When placing a buy or sell order, there are two ways you can trade. Shares can be traded at market order, which
means buying at the prevailing market price. The alternative is the limit order, in which you set the minimum or maximum
price.
What are interest rates going to do? Investors who buy and sell bonds before maturity are exposed to many risks,
most importantly changes in interest rates. When interest rates increase, new issues will pay a higher yield and the value of
existing bonds will fall. When interest rates decline, the value of existing bonds will rise as new issues pay a lower yield.
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Dos and Don’ts
Do
Before you buy, check how quickly you will be able to sell if necessary, and at what discount and dealing fee.
Don’t
Don’t, unless you are completely confident, invest in only one type of bond or security. An exchange-traded fund or
an index fund might be a much safer bet.
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Further reading Current tab: Books:
Articles:
Websites:
Books:
Fabozzi, Frank J., and Franco Modigliani. Capital Markets: Institutions and Instruments. 4th ed. Upper Saddle
River, NJ: Prentice Hall, 2008.
Maginn, John L., Donald L. Tuttle, Jerald E. Pinto, and Dennis W. McLeavey (eds).Managing Investment
Portfolios: A Dynamic Process. 3rd ed. Hoboken, NJ: Wiley, 2007.
McInish, Thomas H. Capital Markets: A Global Perspective. Malden, MA: Blackwell Publishers, 2000.
The Bond Market: Its Structure and Function
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Checklist Description
This checklist describes the bond market and outlines its structure and function.
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Definition
The bond market is the market for debt securities in the form of bonds where buyers and sellers determine their prices and
therefore their accompanying interest rates. It is also known as the fixed-income or debit or credit market.
In purchasing a bond you are effectively lending money to a government, corporation, or municipality, known as the issuer,
which agrees to pay you a certain rate of interest during the lifetime of the bond and repay its principal or face value when it
matures or becomes due.
The international bond market is estimated to have a size of almost US$47 trillion. The US bond market is the largest in the
world, with an outstanding debt of more than US$25 trillion. In 2007, the volume of trade in the US bond market was
US$923 billion.
Since 2000, the international bond market has doubled in size as a result of the activity of big multinational companies.
According to the International Capital Market Association, about US$10 trillion worth of bonds were outstanding in 2007.
The individual government bond markets have a high level of liquidity and considerable size—these are included in the
international bond market. They are noted for their low credit risk and are unaffected by interest rates.
Trading generally takes place over the counter (known as OTC) between broker dealers and big institutions. The stock
exchanges list a small number of bonds too.
The largest centralized bond market is the New York Stock Exchange (NYSE), which mainly represents corporate bonds. In
contrast to this, most governments have bond markets that lack centralization, mostly due to the fact that bond issues vary
widely and there is a large choice of different securities by comparison.
Most outstanding bonds are in the hands of institutions: pension funds, mutual funds, and banks. This is because individual
bond issues are so specific and a large number of smaller issues lack liquidity.
The volatility of the bond market is in direct proportion to the monetary and economic policy of the country of the participant.
The main difference between corporate and government bonds is that the latter are guaranteed and thus carry a low risk of
investment, albeit at a lower rate of return. Corporate bonds generally offer a higher rate of return on investment, but carry
more risk—if the company fails, the bondholder risks losing their investment.
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Advantages
It is considered a wise move to invest in bonds as part of a considered diversified investment portfolio that also
consists of stocks and cash. They are considered to be a relatively safe investment for increasing capital and receiving a
reliable interest income. The principal and interest are set at the time the bond is purchased. If the owner collects the
coupon and holds it to maturity, the market is irrelevant to final payout. As a long-term investment, bonds may be considered
a wise choice—bearing in mind the disadvantages.
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Disadvantages
Bonds are not advisable for short-term savings for the individual participant in the market.
Long-term commitment is essential as the participant who cashes in before maturity is open to the risk of
fluctuations in interest rates. Whenever there is an increase in interest rates, there is a corresponding decrease in the value
of existing bonds. Conversely, a decrease in interest rates will correspond to a rise in the value of existing bonds. This is due
to the fact that new issues pay out a lower yield. The basic concept of bond market volatility is that the value of bonds and
changes in interest rates run inversely to each other.
When interest rates drop, investors have to reinvest their interest income and return of principal at lower rates.
The final purchasing power of an investment in bonds is reduced by a corresponding increase in inflation, which
also results in higher interest rates and correspondingly lower bond prices.
If there is a decline in the bond market as a whole, individual securities also fall in value.
Timing is crucial: a security may in the future unexpectedly underperform relative to the market.
A bond may perform poorly after purchase, or it may improve after you sell it.
Corporate bonds have relatively low liquidity compared with government bonds, which usually have a short lock-in
period (i.e. they can be cashed in quickly).
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Action Checklist
Make sure that you can afford to invest in long-term savings before you commit yourself to taking out bonds.
Have another form of savings as an emergency fund in case you meet with an unexpected financial problem in the
future.
Read all the available literature and take advice from an impartial financial consultant before making a final
commitment.
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Dos and Don’ts
Do
Be sure to choose a security that is approved by a financial expert.
Don’t
Don’t rush into a transaction or pay over the odds for it.
Raising Capital by Issuing Bonds
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This checklist outlines how companies can raise finance through a bond issue.
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Definition
Raising capital by issuing bonds is a popular alternative to selling shares, as it allows a company to avoid relinquishing
ownership of part of the business. A bond is a loan in the form of a debt security. The authorized issuer (the borrower) owes
the bondholder (the lender) a debt and has an obligation to repay the principal and the coupon (interest) on the maturity of
the loan. Bonds enable the issuer to finance long-term investments with external funds.
The loan collateral may be the company’s land, buildings, or other physical assets that can be sold off if the issuer defaults
on repayment of the principal. In today’s bond markets, however, a much wider range of assets can fulfill the function of
collateral, such as receivables that produce a flow of income.
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Advantages
Taking on debt by issuing bonds is usually cheaper than either a bank overdraft or the cost of raising equity
through a share issue. A major advantage is that the return on debt (interest) is tax-deductible, whereas the return on equity
(dividends) is paid out of a company’s profits, which are taxed before dividend payments can be made to stockholders.
Financing by raising debt is a useful way of monitoring a corporation’s overall health, as the ability to repay the
debt reflects the overall financial stability of the company.
Bonds offer a more secure return for investors—dividends are paid out purely at the discretion of the company,
whereas interest on debt must be paid according to the set terms of the bond.
Debt issuance can also be advantageous from a governance point of view. In the United States and United
Kingdom, for example, creditors have no influence on the board or company policy—unlike stockholders, who often have the
right to vote on policies and the appointment of directors. Financing through debt can thus be very useful for companies that
do not want to relinquish control to others.
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Disadvantages
The risks for bondholders rise as more debt is issued.
The debt covenants may prove too restrictive for the company. A company that is highly leveraged is more likely to
face cash flow difficulties as it has to meet the coupon payments regardless of its income. The cost of servicing the debt
may rise beyond the ability to pay, either because of external events, such as falling income, or because of internal
problems, such as poor company management. The company may find that it runs into solvency problems if the amount of
debt becomes higher than the value of its realizable assets. Thus, the cost of debt rises as its proportion rises in relation to
equity. The higher the debt-to-equity ratio, the greater the risk.
If the company is publicly listed on a stock exchange, the risk to stockholders increases when debt is issued. This
is due to the increased claims of the creditors, or bondholders, on the company’s capital and earnings, which must be used
to service the debt before anything else. And if the company has problems servicing the debt, stockholders risk the loss of
their equity in the case of bankruptcy.
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Action Checklist
Choose the right type of debt. For large investments, you generally have a choice of borrowing the principal from a
creditor, usually a bank, or issuing bonds underwritten by the bank that can be sold to investors. If the bond can be retraded,
it is beneficial for the bondholders as they can exit at the right moment, but the company still has access to the funds via
new purchasers.
Choose the right interest rate. Bonds usually have either a fixed interest rate for a specified period or a floating rate
linked to an agreed index. Fixed-rate debt means that the issuer knows the exact cost across the debt’s lifetime and can
budget for the principal and interest payments each year. Floating-rate debt usually has a mark-up over the base rate set by
the central bank in charge of the currency that is being borrowed, meaning that the issuer may have to pay more if monetary
policy is tightened and interest rates rise during the period of the loan.
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Dos and Don’ts
Do
Do a full cost analysis to determine if debt will be cheaper for the company than equity.
Take into account that unexpected market volatility and inflation will affect the coupon level.
Don’t
Don’t issue bonds if you think that meeting regular payments to the bondholders will overstretch your cash flow.
Stock Markets: Their Structure and Function
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This checklist describes stock markets, their structure and function, reasons for investing, and some things to look out for.
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Definition
A stock market is a private or public market for the trading of stocks and shares in companies and derivatives of company
stocks at an agreed price. These include securities listed on a stock exchange as well as those traded privately. A stock
market is sometimes also known as an equity market.
The estimated size of the world stock market is around US$51 trillion. Even larger, it is estimated that the world derivatives
market is worth about US$480 trillion face, or nominal, value; that is well over ten times the size of the whole world
economy. However, the derivatives market is stated in terms of notional values and therefore cannot be directly compared to
stocks, which refer to an actual value.
Stock markets specialize in bringing buyers and sellers of stocks and securities together. Famous stock exchanges include
the New York Stock Exchange, the London Stock Exchange, the Deutsche Börse, and the Paris/Amsterdam Euronext.
A stock market is an important way for a company to raise money. It allows businesses to be publicly traded, or to raise
extra capital for expansion by selling shares in the company in a public market. Share owners then have a share of
ownership of that company. A stock market provides liquidity to give investors the chance to sell securities rapidly and
easily. This makes investing in stocks attractive compared with, for example, real estate, which is less liquid.
The price of shares and other assets plays an important part in the economic activity of a country. It can influence or reflect
the social mood of a country. A stock market is often taken as a primary indicator of a country’s economic well-being as it
enables the efficient allocation of capital. Stock prices reflect where capital is being invested, or should be. If share prices
are rising, this is usually coupled with increased business investment, and vice versa. Share prices also have an influence
on the wealth of households, and thus on how much they spend. Central banks watch the movement of the stock market
closely and also the smooth operation of financial system functions. This was highlighted in September 2008, when stock
markets plunged in response to failing financial institutions—particularly in the United States—and central banks stepped in
to try to arrest the slide.
Stock exchanges act as a clearing house for each transaction made on them. This means that they guarantee payment to
the seller of the security and collect and deliver the shares. In this way there is no risk to a buyer or seller of a default on the
transaction.
With these activities functioning smoothly, economic growth is enhanced because lower costs and enterprise risks help to
promote the production of goods and services, and employment. As such, financial systems contribute to increased
prosperity.
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Advantages
Trading in stock and shares can be done rapidly and easily, making them an attractive liquid investment.
A rising stock market helps to boost prosperity in a country and promote a confident social mood.
Stock markets allow anyone to participate in the growth of any listed company.
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Disadvantages
Share prices can change very quickly in today’s electronic markets, driven by trading by very large institutions.
A falling stock market creates an unhappy mood in a country and can lead to difficult economic times and
unemployment.
Prices of stocks and shares can fall as well as rise.
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Action Checklist
Check the history of a stock market. How long ago was it established? How stable is it? How does its average
performance rate compared with other exchanges?
Check the risks involved in a particular stock market. Is it easy to buy and sell on your chosen stock market? What
fees are involved? How well is it regulated? Some countries regulate less well than others, increasing your risk.
Check how easy it is to find current prices on your chosen stock market.
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Dos and Don’ts
Do
Understand the volatility and risk of a stock market before investing.
Understand the risks involved. Some emerging markets have higher growth potential, but much higher risks too.
Keep an eye on the progress of the stocks and shares you have purchased.
Don’t
Don’t rush into stock market investments.
Don’t buy when the price is high.
Don’t sell when the price is low.
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Further reading Current tab: Books:
Websites:
Books:
Becket, Michael, and Yvette Essen. How the Stock Market Works: A Beginner’s Guide to Investment. 4th ed.
London: Kogan Page, 2011.
Chapman, Colin. How the Stock Markets Work. 9th ed. London: Random House Business Books, 2006.
Gough, Leo. How the Stock Market Really Works. 5th ed. Financial Times Guides Series. Harlow, UK: FT Prentice
Hall, 2011
The Foreign Exchange Market: Its Structure and Function
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Checklist
This checklist describes how the foreign exchange market works and the types of transactions conducted on it.
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Definition
The foreign exchange market, also known as the forex, FX, or currency market, involves the trading of one currency for
another. Prior to 1996 the market was confined to large corporate banks and international corporations. However it has
since opened up to include all traders and speculators. Today, the average daily turnover in forex markets is US$1.9 trillion,
according to the Bank of International Settlement’s Triennial Survey. The market is growing rapidly as investors gain more
information and develop more interest.
In trading foreign exchange, investors bet that one currency will appreciate over another; they profit when they bet correctly
and collect the profit in the form of an interest rate spread when they return to the original currency. The profit margins are
low compared with other fixed-income markets. Large trading volumes can, however result, in very high profits. Most forex
trading takes place in London, New York, and Tokyo, with most trading activity in London, which dominates the market at
30% of all transactions. New York’s market share is 16%, and Tokyo’s has fallen to 10% due to the growing prominence of
Singapore and Hong Kong. Singapore has become the fourth largest exchange market globally, and Hong Kong is the fifth,
having overtaken Switzerland. The various players in the foreign exchange market include bank dealers, 16% of which are
international investors and speculators. Banks account for almost two-thirds of forex transactions; of the rest, about 20% is
mainly attributable to securities firms that operate in the international debt and equity markets.
One type of very short-term transaction is the spot transaction between two currencies, delivering over two days and using
cash as opposed to a contract.
In a forward transaction, the money is not exchanged until an arranged date and an exchange rate is agreed in advance.
The time period ranges from days to years. Currency swaps are a popular type of forward transaction; these involve the
exchange of currency by two parties for an agreed length of time and an arrangement to swap currencies at an agreed later
date. Another type is a foreign currency future, which is inclusive of interest. A standard contract is drawn up and a maturity
date arranged. The time schedule is about three months.
In a foreign exchange option (FX option), the most liquid and biggest options market in the world, the owner may elect to
exchange money in a designated currency for another currency at an agreed date in the future. This type of transaction
depends on the availability of option contracts on an organized exchange. Otherwise, such forex deals may be carried out
using an over-the-counter (OTC) contract.
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Advantages
The forex market is extremely liquid, hence its rapidly growing popularity. Currencies may be converted when
bought or sold without causing too much movement in the price and keeping losses to a minimum.
As there is no central bank, trading can take place anywhere in the world and operates on a 24-hour basis apart
from weekends.
An investor needs only small amounts of capital compared with other investments. Forex trading is outstanding in
this regard.
It is an unregulated market, meaning that there is no trade commission overseeing transactions and there are no
restrictions on trade.
In common with futures, forex is traded using a “good faith deposit” rather than a loan. The interest rate spread is
an attractive advantage.
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Disadvantages
The major risk is that one counterparty fails to deliver the currency involved in a very large transaction. In theory at
least, such a failure could bring ruin to the forex market as a whole.
Investors need a lot of capital to make good profits because the profit margins on small-scale trades are very low.
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Action Checklist
Be alert for unanticipated corrections and wild fluctuations in currency exchange rates.
Look for volatile markets that offer opportunities for quick profit.
Watch out for lost payments, and be aware of delays in payments and money received. There may also be
discrepancies between bank drafts received and the original price of the contract.
It is wise to exit from the forex market at the point when your profit targets have been achieved as this ensures that
you stay within the profit zone.
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Dos and Don’ts
Do
Make sure when you pick a pair of currencies that you understand their relationship.
Use a trading system that you can trust with your money.
Don’t
Don’t be greedy: take your profits at the right time.
Don’t be emotional when you trade.
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Further reading Current tab: Books:
Websites:
Books:
Archer, Michael Duane. Getting Started in Forex Trading Strategies. 7th ed. Hoboken, NJ: Wiley, 2008.
Dicks, James. Forex Made Easy: 6 Ways to Trade the Dollar. New York: McGraw-Hill, 2004.
Shamah, Shani Beverly. A Foreign Exchange Primer. Wiley Finance Series. Chichester, UK: Wiley, 2003
Money Markets: Their Structure and Function
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Checklist Description
This checklist is designed to highlight the key features of money markets. It looks at how they work, and the reasons for their
use.
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Definition
Money markets are the part of the global financial market that deals with short-term lending and borrowing. They are often
used as a solution to short-term cash needs by governments, large institutions, and, sometimes, individuals.
Generally, participants in the money markets are retail banks and large corporate organizations that can trade with each
other using the benchmark of the London Interbank Offered Rate (Libor). This rate is generated on a daily basis through
researching the interest rates at which banks are prepared to lend on unsecured assets. The money markets are considered
to be quite a low-risk investment, but they do not promise particularly high gains either.
Typically, a transaction in a money market will be of very short duration and will be of a particular type of dealing called
“paper.” Examples of papers are treasury bills, repurchase agreements, and foreign currency swaps. The time frame of the
transaction may range from one day to 13 months, and it is this short-term approach that sets money markets apart from the
capital market.
Repurchase agreements, or “repos,” are very short term loans, often lasting for only a day, where assets are sold to an
investor with an agreement to repurchase them at a later date for a fixed price. In foreign currency swaps, currencies are
swapped with an agreement to reverse the deal at a later, agreed date.
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Advantages
For an organization in need of a quick cash injection the money markets are extremely useful. They generally allow
easy borrowing or lending in a low-risk environment. For example, a one-day loan where the seller can repurchase its
securities for a set price at a certain time in the future is extremely safe. If we compare this transaction to those made in the
unforgiving world of the stock market, where investors have no control over the future performance of their stocks, it is easy
to see the appeal of money markets.
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Disadvantages
Money markets are particularly low risk and therefore are not suitable for an investor looking for high returns.
The money markets are used for short-term loans only and are not designed to achieve long-term growth of
assets.
Despite the apparent low risk of the money markets, all transactions in them must be properly assessed in the
context of the global market. When the global financial markets go through one of their periodic cycles of turmoil and
instability, one should always err on the side of caution with any investment.
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Action Checklist
Consider your reasons for investing. Do you require a quick cash release or are you planning for the long term?
What kind of investment are you looking for? Consult your financial adviser to determine what type of transaction
would work best for your company.
Check carefully on the financial status of the organization with which you are considering entering into a money
market agreement.
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Dos and Don’ts
Do
Research all the available fundraising options fully.
Give yourself as comprehensive an understanding of the current financial market as you can before investing.
Examine your motives for using the money markets as a long-term investment may make more sense.
Don’t
Don’t invest in the money markets if you are looking for a high return on your investments.
Don’t believe that because the money markets are low risk your assets are perfectly safe.
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Further reading Current tab: Books:
Article:
Websites:
Books:
Choudhry, Moorad. Bond and Money Markets: Strategy, Trading, Analysis. Oxford: Butterworth-Heinemann, 2003.
Choudhry, Moorad. The Money Markets Handbook: A Practitioner’s Guide. Singapore: Wiley, 2005.
Derivatives Markets: Their Structure and Function
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This checklist describes derivatives markets, their structure and function.
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Definition
Derivatives markets attract three main types of participants: hedgers, speculators, and arbitrageurs. Hedgers reduce the risk
that they face in terms of asset prices by using futures or options markets. Speculators focus on future price movements, for
which futures and options contracts provide them with extra leverage. Such investors speculate on potential gains and
losses and help to make the market more liquid. Arbitrageurs, on the other hand, take advantage of price differences in
different markets. For example, they use the discrepancy between cash prices and future prices to make a profit.
The derivatives market can be seen as providing a number of economic benefits. Being speculative in nature, it provides the
investor with a perception of the market not only in terms of current prices, but also in terms of the future. A further function
is that derivatives markets transfer risks from those who have no appetite for them to those who do. Finally, the underlying
cash market enjoys higher trading volumes from more players as a result of risk mitigation.
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Advantages
The derivatives market is a thoroughly exciting one for certain types of investor. It attracts creative, educated,
vibrant, and intelligent investors who make optimal use of the opportunities offered and transfer their enthusiasm to new
entrants as well. This perpetuates the entrepreneurial spirit within the economy, and not only creates better and new
products but also has a positive effect on the job market.
Importantly, derivatives markets can be extremely beneficial for both individuals and the overall economy of a
country. Entrepreneurial players are energized to create new businesses, products, and concomitant employment
opportunities from the profits they make from the derivatives markets. In addition, derivatives markets then also increase
savings and long-term investment through the risk-transferring function. In this way, participants in the market can expand
the volume of their activity as a result of the wide variety of choices available.
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Disadvantages
The main disadvantage of the derivatives markets arises from the lack of thorough investigation into how to use
the risk transfer factor. This can result in difficulty when trying to margin transactions, or to monitor various participants’
activities and tailor one’s own activity accordingly.
A lack of thorough research and sound investment may lead to investment losses for which the investor is not
prepared. The risk transfer factor therefore needs to be applied in a targeted way in order to ensure that the investor does
not take unnecessary risks.
Several risks may be involved for those who are not thoroughly familiar with speculative markets. Even though
risks can be transferred, remember that the derivatives market operates on a paradigm of uncertainty. An investor who is not
comfortable with uncertainty in investment might be more comfortable taking on a different type of investment structure.
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Action Checklist
Make sure you have thoroughly investigated your company’s ability to take risks and absorb possible losses if you
decide to participate in the derivatives market.
You must be comfortable with a significant element of speculation.
Seek advice and guidance from the relevant professional experts.
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Dos and Don’ts
Do
Investigate your options in this market thoroughly.
Ensure that you are fully aware of the risks you will be taking, and of what level of risk you are comfortable with.
Make an informed choice, particularly where risk is concerned.
Make sure that you continually review your risk level and modify it if and when necessary.
Don’t
Don’t take unnecessary risks.
Don’t forget to check regularly that you are not exceeding the risk level at which you are comfortable.
Don’t approach the derivatives market with a careless attitude. Make sure that you are always aware of trends and
speculations in the market.
Don’t invest if you are not completely comfortable with participating in a speculative market.
The Interbank Market: Its Structure and Function
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This checklist defines the interbank market and outlines its structure and function.
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Definition
The interbank market is the market on which individual banks conduct transactions among themselves. It consists primarily
of commercial and investment banks that buy and sell currencies. They are obliged to establish set rules and clearly defined
lines of credit between themselves before they can trade. The interbank market has the greatest monopoly of all trading,
both commercial and speculative. Members can influence supply and demand, and their trading activities can alter the
exchange rates at any time. They have most power selling in the foreign currency exchange market.
These banks trade on their customers’ behalf, but their other important purpose is to make profits for themselves. They have
at their fingertips specialist knowledge and awareness of the market, as well as the skills required to keep an eye on the
activities of their co-participants in the market.
Since the early 1980s there have been many important developments in the interbank market. The introduction of Reuters’
electronic brokerage system, known as the Monitor Dealing Service, followed by its Dealing 2000-1 system in 1989, are
examples. However, the market was entirely transformed by the introduction of Reuters’ Dealing 2000-3 system in 1992 and
the subsequent launch by FX market-making banks of the Electronic Broking Services (EBS) system, which made possible
the automatic matching of quotes from dealers. Since the introduction of electronic systems, dealers have been able to
conduct a number of trades simultaneously and can achieve a greater level of efficiency in doing so, along with tighter
spreads and lower costs. There is a consequent greater level of transparency, and a greater number of players can now
operate alongside the commercial and investment banks.
EBS and Reuters D2/Dealing 3000 are direct competitors—a trader’s choice of which system they will use usually depends
on the currencies they need to trade. EBS is standard for matching euros, US dollars, yen and Swiss francs with each other,
whereas D2 is generally used for all other currency pairings.
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Advantages
The close interbank relationships described above are valuable in that they give all members access to the
cooperating institutions within a relationship. Their combined expertise serves as a useful role model for other lenders, who
are monitored by those banks. The interbank system also enables the smaller, less powerful banks to be monitored with
regard to their levels of market discipline and compliance.
Competition between the member banks ensures that there are tight spreads and fair pricing. For individual
investors this is the source of their price quotes as the interbank market is dominated by larger players: customers are the
large mutual and hedge funds and the big multinational corporations.
All the member banks can see the best market rates.
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Disadvantages
Smaller banks suffer restrictions in dealing with the larger banks and as a result have less favorable pricing
available to them. It is even worse for individual investors, who cannot access the interbank market at all. The lowest quote
that banks are able to give is between US$10 million and US$100 million. This means that individuals have to rely on online
market-makers for their pricing, which may not be very competitive. Only the big players with plenty of capital really benefit
from the interbank market.
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Action Checklist
Do your homework diligently, accessing as much help as you can in securing as good pricing as possible.
Seek the advice of a skilled financial expert.
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Dos and Don’ts
Do
Take utmost care with your choice of interbank broker, especially for foreign exchange transactions.
Be diligent and persevere in obtaining the best deal possible with your broker.
Don’t
Don’t rush into a transaction.
Don’t give in to persuasive selling by your broker.
Understanding and Using Currency Swaps
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This checklist explains what a currency swap is and why it is used. Currency swaps are sometimes called cross-currency
swaps.
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Definition
A currency swap is a foreign exchange transaction in which two or more parties agree to exchange a set amount of one
currency for another for a specified period of time. At the end of the determined time-span, each party returns to the other
the original sum swapped. Currency swaps are a useful tool for legitimately bypassing foreign exchange controls. Currency
swaps are typically negotiated for any period of time up to 30 years’ maturity.
Under international accounting rules, a currency swap is not considered to be a loan and therefore does not usually appear
on a company balance sheet. Rather, it is accounted as a foreign exchange transaction (the short leg), with the requirement
to close the swap (the far leg) being accounted as a forward contract. All cash flows associated with the swap are paid—the
initial receipt/payment of loaned principal, the payment/receipt of interest (in the same currency), and the ultimate
return/recovery of the principal upon maturity.
It is not uncommon for a company to shop around to reduce the amount needed to service a debt. By borrowing at a lower
cost in a particular currency and then exchanging it for a debt in the currency the company really desires, both parties can
improve the condition of their debt while also maximizing their cash flows.
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Advantages
The main advantage of entering into a currency swap is its flexibility—the maturity of a swap is usually negotiable for at least
10 years. Entering into a currency swap can help both parties limit or manage their exposure to fluctuations in interest rates
or to obtain a lower interest rate—a foreign company is unlikely to have access to better rates than a domestic company. As
companies service their swap obligations with cash flow generated in a foreign currency, they thus also reduce their
exchange rate risk exposure. An additional benefit to engaging in a currency swap is the reduction of counterparty risk, as
evidenced by the bid–ask spread.
By definition currency swaps are also combined with an interest rate swap in two currencies. The terms of a swap may be
drawn up to have fixed versus floating payments in different currencies beyond fixed rates.
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Disadvantages
Any benefit of entering into a currency swap must be balanced against the costs of the transaction and managing
risks such the pre-settlement risk and the settlement risk. However, the chief risk in engaging in a currency swap is that the
other party may fail to meet its obligations either during the period of the swap or upon maturity. Should one party wish to
exit the swap before maturity, the exiting party must secure the consent of its counterparty before pursuing a mutually
agreed exit strategy, much as in the case of selling an exchange-traded futures or option contract before maturity. Some exit
routes include the following:
a. Entering into an offsetting swap. For example, the exiting party could enter into a second swap, this time
receiving a fixed rate and paying a floating rate.
b. Selling the swap to a third party. As swaps have a calculable value, one party may sell the contract to a
third party, with the permission of the counterparty.
c. Purchasing a “swaption.” This allows a party to set up, but not enter into, a potentially offsetting swap at
the time they execute the original swap.
Understanding and Using Interest Rate Swaps
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This checklist explains what an interest rate swap is and why it is used.
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Definition
An interest rate swap is a popular, highly liquid derivatives instrument in which one party exchanges its stream of interest
payments for another party’s stream of cash flows. Interest rate swaps are used by hedgers to manage their fixed or floating
assets and liabilities, and by speculators to profit from changes in interest rates.
There are various types of interest rate swap, the most common being where one party agrees to pay a fixed rate (the swap
rate) to the other party, which in return pays a floating rate to the first party. The rate is usually denominated in a particular
currency, which is then multiplied by a notional principal amount (for example, US$1 million). The notional amount is
generally used only to calculate the size of cash flows to be exchanged. The floating rate is usually pegged to a reference
rate such as the Libor, and the interest payments are settled net. When the swap is initiated, it is priced so that its net
present value is zero.
Other popular swap types are fixed–fixed, floating–floating, or a combination including different currencies (interest rate
swaps are often combined with currency swaps).
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Advantages
The chief advantage of an interest rate swap is that it limits a company’s exposure to interest rate fluctuations, and thus
reduces risk. By swapping interest rates, a firm is able to alter its interest rate exposures and bring them in line with
management’s appetite for interest rate risk.
Where there is a positive quality spread differential, a further benefit is the opportunity for arbitrage. This enables each party
to take advantage of the other’s credit-worthiness in the swap.
Other pluses include increasing the certainty of an issuer’s future obligations, saving money should interest rates decline
(here, the party paying a floating rate will be the beneficiary of a rate drop), the option of revising your debt profile to benefit
from anticipated future market conditions, and reducing the amount of debt service.
Interest rate swaps generally involve minimal cash outlay. It is usual that on a payment date only the difference between the
two payment amounts is paid to the entitled, rather than an exchange of the full amount of interest.
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Disadvantages
The downside to participating in an interest rate swap is the exposure to risk, typically interest rate risk and credit risk. The
interest rate risk occurs when there are changes in the floating rate. In a standard fixed-for-floating swap, the party paying
the floating rate benefits if rates fall but is exposed if rates rise, in a similar fashion to holding a long bond position. The
credit risk remains whether the swap is in-the-money or not. If one party to the swap is in-the-money, then the risk is their
exposure to the other party defaulting
Understanding and Using Inflation Swaps
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This checklist explains what an inflation swap is and why it is used.
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Definition
An inflation swap involves the use of inflation derivatives (or inflation-indexed derivatives) to transfer inflation risk from one
party to another. The derivatives used may be over-the-counter or exchange-traded derivatives. Inflation swaps have
become increasingly popular since the turn of the century as pension funds, for example, recognize the need for inflation-
linked assets that match future liabilities. Conversely, borrowers such as governments or large corporations understand that
inflation-linked assets or revenues can be funded by inflation-linked debt. Inflation swaps frequently include real rate swaps,
such as asset swaps of inflation-indexed bonds. Inflation swaps are simply a linear form of such derivatives. Real rate swaps
consist of the nominal interest swap rate minus the corresponding inflation swap.
There are three main types of inflation swap. In a standard interbank inflation-linked swap, or zero-coupon inflation-linked
swap, cash flow is exchanged on the maturity date. This swap pays out the exact value of the cumulative inflation for a fixed
capital sum over a determined period. This is a good option for investors, particularly pension funds, seeking an investment
mix aimed at compliance with long-term, inflation-related obligations.
In a year-on-year inflation-linked swap, inflation is used on an annual basis rather than a cumulative one. This structure is
suitable for investors seeking to protect cash flow. Typically, an inflation swap is priced on a zero-coupon basis, with
payment exchanged upon maturity. One party pays the compound fixed rate, while the other pays the actual inflation rate for
the term of the swap. In Europe, inflation swaps are typically paid on a year-on-year basis where the year-on-year rate of
change of the price index is paid. In the United States, payment is more typically on a month-on-month basis, although the
inflation rate used is still the year-on-year rate.
In an inflation-linked income swap two cash flows are exchanged, each of which follows the inflation index. One party pays a
fixed inflation increase annually over the period of the contract. The other party pays the actual inflation over the period of
the contract. The swap itself consists of a series of zero-coupon swaps.
Other traded inflation derivatives include caps, floors, and straddles, which are usually priced against year-on-year swaps.
The inflation derivatives market in the United Kingdom is substantial, although the equivalent market in the eurozone is
many times bigger.
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Advantages
Public authorities, and companies dealing in utilities, real estate, and distribution all benefit from high inflation as it brings
bigger profits. Conversely, insurers, pension funds, and private investors fare better when inflation is low, as otherwise they
face a shrinking margin. Thus, there is a potential market for selling or buying inflation. The key advantage of entering into
an inflation swap is being able to hedge against future price rises or diminishing margins. By selling inflation in an inflation-
linked swap, future income linked to inflation can be protected.
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Disadvantages
The main disadvantage of participating in an inflation swap is the risk that inflation rates may change drastically as a result
of unexpected shifts in the global economy. Such changes can expose parties to loss of profit or negative equity.
Using Structured Products to Manage Liabilities
by Shane Edwards
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Table of contents
Executive Summary
Introduction
Anatomy of a Structured Product
Legal Form
Client Types and Common Uses of Structured Products in Liability Management
Practical Considerations
Conclusion
Making It Happen
Notes
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Executive Summary
Structured products (SPs) are derivative contracts that are tailored for a specific purpose, such as hedging the
value of an uncertain future liability.
The value of a SP is derived from one or many underlying reference asset values, which causes uncertainty in the
value of the liability to be hedged.
SPs are typically transacted between a client and an investment bank, and can take various legal forms.
The fact that SPs are flexible and can be tailored to client needs distinguishes them from standard derivatives,
which have generic fixed terms.
However, SPs tend to be regarded as more complex financial instruments, and they are more difficult to value than
vanilla derivatives.
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Introduction
Only a decade ago, the use of structured products (SPs) was largely confined to sophisticated institutions that used them for
risk management purposes. Now SPs are embraced across the client spectrum and are owned by millions—from retail
individuals investing in capital-protected equity products, to global corporations that tailor SPs to meet their often complex
and highly specific liability management needs.
In the liability management arena, SPs have an important role to play due to their highly customizable nature. They are used
by corporate treasurers as a way of actively managing borrowing costs and hedging foreign exchange liabilities. Many
companies have also embraced SPs, outside of treasury, to manage expected future liabilities (for example, airlines hedging
the price of jet fuel or importers/exporters hedging the foreign exchange rate). SPs are also used by many pension funds as
a strategic initiative to manage the asset–liability mismatch and tailor the pension deficit risk profile.
The increased appetite for SPs is a result of improved client education and the rapid pace of innovation at investment banks,
where SPs have become a major source of business. The growth in SP volumes is expected to continue its rapid pace in the
years ahead.
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Anatomy of a Structured Product
A derivative is a financial instrument that derives its value from one or more underlying reference asset values. Derivatives
can range in complexity from very simple with standardized terms (vanilla derivatives), to very complex with highly
customized features (exotic derivatives). Broadly, there are three levels of complexity in derivatives, listed here in order of
complexity:
Linear derivatives (for example, futures, forwards, zero strike calls), which reflect the performance of an underlying asset
on an almost one-to-one basis but without legal ownership of the underlying asset. These derivatives can be simply priced
through arbitrage (cost of carry) arguments.
Nonlinear derivatives (for example, call options), where at expiry the price of the derivative will vary linearly with the
underlying asset price if the underlying is above a predefined strike level. If this is not the case, the option price will be worth
zero. Well-understood models are available that rely heavily on the volatility of the underlying asset to determine the
derivative price.
Exotic derivatives, which have path-dependent payouts, restriking features, or hybrid (multiasset class) characteristics.
They require sophisticated mathematical models to price and are highly sensitive to calibrations of the underlying probability
distribution and correlation assumptions (in the case of multiasset underlyings).
Any of the three derivative types may be regarded as structured products due to the amount of customization that is
contained in the contract terms. Common customizations include:
Underlying assets (underlyings): These may include anything that is transparent and tradable, such as equities,
interest rates, foreign exchange rates, commodities, and inflation. Hybrid SPs can be created where multiple asset classes
are used.
Tenor: Clients are able to tailor the maturity of a SP to any extent where the counterparty providing the hedge
allows it, which in turn is dictated by the liquidity of the underlying asset. SPs can include features that allow early maturity,
such as: puttability (where the client may choose to early-terminate the structure with preagreed payout), callability (where
the hedge counterparty can terminate at its discretion), or automatic termination (where maturity will occur once a predefined
event has occured).
Path dependency: The payouts of many SPs are determined with reference to how the underlyings have
performed through the life of the product, and not simply as a function of the final underlying asset level. Examples are Asian
options (where the average level of an underlying is calculated) and lookback or barrier options (where the highest or lowest
observed levels of an underlying determine the payout).
Payouts: SPs can have interim payouts (coupons) and/or a final payout at maturity as specified.
Currency: SP payouts are often requested in currencies other than the currency of the underlying asset; such
products are known as quanto or composite options.
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Legal Form
A structured product is a legally binding financial contract between a client and an investment bank, stating the specific
terms that have been agreed. The legal form of the transaction is referred to as a wrapper, and the most common wrappers
are:
Over-the-counter (OTC). This typically means that a client makes an upfront payment equal to the offer price of the SP. In
return, the bank (as per the terms of the SP) may pay the client coupons and/or a payment at maturity, all of which are
typically dependent on the performance of the underlying reference assets.
Structured note. The client pays the principal amount to the bank at inception. In return, the bank sells the client a note,
which is typically a senior unsecured debt obligation of the bank. The note will reflect the terms of the transaction and
specify payments, normally including the return of the principal amount at maturity (for principal protected notes), or possibly
some principal loss (in the case of nonprincipal protected notes), depending on the performance of the underlying.
Swap. In a swap there is no exchange of principal. Typically, the client will pay floating Libor (minus a spread) and the
investment bank will pay periodic amounts contingent on the performance of the underlying.
Other forms. There are myriad wrappers that find preference with certain clients or in certain jurisdictions, depending on the
tax consequences, counterparty risk exposure, and local regulation. Other wrappers include structured deposits and UCITS
III funds,1 for example.
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Client Types and Common Uses of Structured Products in Liability Management
Due to their flexibility, SPs are chosen in a variety of liability management situations and by an array of users. They are
implemented as both a proactive (value enhancing) and a reactive (risk hedging) tool. Some examples are given below for
corporate treasurers who manage interest rate exposure, borrowing requirements, and currency exposure, and for pension
managers who employ SPs in the asset–liability management framework.
Managing interest rate exposure (reactive example). A corporation has existing floating-rate debt and is concerned that
interest rates will increase. It may buy a cap with the same remaining debt maturity, which means it will pay a premium
upfront and will receive periodic payments if the floating reference rate is above the agreed cap rate. Thus the company can
ensure that its net floating payments will not exceed a capped rate.
Managing interest rate exposure (proactive example). A corporation is aware that its business revenue varies inversely
with the level of prevailing interest rates. Working with an investment bank, the treasurer decides to restructure its borrowing
and issue an inverse floater, which means that its interest payments will decline as the floating reference rate rises (and its
business revenues contract), and its interest payments will rise if floating reference rates fall (and business revenues
expand), providing profit stabilization through the economic cycle.
Using SPs for new borrowing requirements (hybrid example). A Japanese company could borrow in US dollars to
establish a US-based distribution center for products it manufactures in Japan for a fixed cost in Japanese yen. A major
threat to profit is the selling price, which is fixed in US dollars. Again, looking to stabilize profit, the company could buy a SP
where it will receive coupons if the dollar depreciates or if the US interest rate rises.
Hedging input prices. Steel is a vital input for automobile manufacturers. In forecasting the budget, auto makers will
estimate the number of cars they need to complete over the following period and the associated revenues and costs.
Clearly, fluctuating input prices could threaten the bottom line. A variety of SPs can hedge this risk, including a forward
purchase agreement that guarantees a fixed price or an option to buy steel at a fixed price in the future, for which the
company could pay an upfront premium.
Pension asset–liability management. Pension managers receive plan contributions and must grow the asset base so that
it exceeds the expected liabilities that arise from funding the future retirement benefits of fund members. The desire to invest
in higher-growth assets (for example, equities) is tempered by the knowledge that they are also higher risk. The fund could
invest in low-risk assets (for example, government bonds) and gain exposure to the outperformance of an equity index over
a bond index, floored at zero, through a tailored hybrid SP. This would allow it to substantially outperform fixed-income
investments during good times, though it would slightly underperform during bad times since the SP premium paid would
detract from a bond-only portfolio.
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Practical Considerations
The attributes that make SPs so desirable—namely their flexibility and highly customizable nature—may also be their
biggest disadvantage. Some predominant practical considerations are:
Pricing: This can be complicated and requires mathematical models and computing power. Most structured
products are priced in a Monte Carlo framework, which is a statistical technique involving the simulation of many paths for
each underlying to assess the expected payout of the SP.
Mark-to-market valuation: Although many SPs have a clearly defined payout at maturity (intended to match a
specific liability, for example), the fluctuations in mark-to-market valuations also depend on other variables. Such variables
include changes in the underlying’s volatility, correlation, or interest rates. Mark-to-market fluctuations can cause balance
sheet volatility, depending on how hedge accounting is implemented.
Secondary market : A client wishing to terminate an SP before its maturity date may be granted an unwind price
from the bank it originally traded with, or enter into a directly opposite trade with another investment bank. This may leave
residual credit risk.
Asset mismatch: Sometimes the precise underlying that constitutes the source of a future liability cannot be used
as the underlying for the SP because it is not readily tradable. This is a particular concern with commodity SPs, which are
often linked to commodity futures rather than physical commodities.
Counterparty risk : Many of the typical SP wrappers, such as OTC, note, and swap, contain credit risk—that is, the
investment bank may not be able to fulfill its obligations when they fall due. This can be mitigated by requiring the bank to
post high-quality collateral against mark-to-market valuations.
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Conclusion
Structured products represent a powerful instrument for the active management of specific liabilities, a liability portfolio, or
asset–liability dilemmas. They can be linked to a wide variety of underlying assets and are fully flexible with regard to
maturity date and conditions observed throughout the term. However, there are a number of practical issues that need to be
understood, including valuation difficulties, counterparty risk, and mark-to-market fluctuations.
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Making It Happen
Most SP experts are found at the major investment banks. As a potential client, a useful starting point is to have clarity on a
specific liability or liability portfolio, and an objective that the company would like to achieve—for example, hedging of price
uncertainties, smoothed performance over business cycles, or achieving a higher return with less risk on surplus funds.
Clients can approach this in a number of ways:
Advanced clients will often propose the details of an SP to investment banks and ask for pricing and trade terms to
see whether they are favorable.
Less-experienced clients will request a meeting with a bank at which SP experts will propose a range of potentially
appropriate products and indicative terms.
Always conduct a scenario analysis of how the liability portfolio behaves before and after the inclusion of an SP
that is being considered, and consider mark-to-market and accounting effects.
Many courses are available that teach elementary SP pricing. This knowledge will help you to understand how
different variables may affect a valuation.
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Notes
1 Undertakings for Collective Investments in Transferable Securities (UCITS) are a set of European Union directives that
allow compliant collective investment schemes to operate freely throughout the European Union. These funds are a versatile
legal structure that often includes embedded structured products.
Derivatives Markets: Their Structure and Function
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This checklist describes derivatives markets, their structure and function.
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Definition
Derivatives markets attract three main types of participants: hedgers, speculators, and arbitrageurs. Hedgers reduce the risk
that they face in terms of asset prices by using futures or options markets. Speculators focus on future price movements, for
which futures and options contracts provide them with extra leverage. Such investors speculate on potential gains and
losses and help to make the market more liquid. Arbitrageurs, on the other hand, take advantage of price differences in
different markets. For example, they use the discrepancy between cash prices and future prices to make a profit.
The derivatives market can be seen as providing a number of economic benefits. Being speculative in nature, it provides the
investor with a perception of the market not only in terms of current prices, but also in terms of the future. A further function
is that derivatives markets transfer risks from those who have no appetite for them to those who do. Finally, the underlying
cash market enjoys higher trading volumes from more players as a result of risk mitigation.
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Advantages
The derivatives market is a thoroughly exciting one for certain types of investor. It attracts creative, educated,
vibrant, and intelligent investors who make optimal use of the opportunities offered and transfer their enthusiasm to new
entrants as well. This perpetuates the entrepreneurial spirit within the economy, and not only creates better and new
products but also has a positive effect on the job market.
Importantly, derivatives markets can be extremely beneficial for both individuals and the overall economy of a
country. Entrepreneurial players are energized to create new businesses, products, and concomitant employment
opportunities from the profits they make from the derivatives markets. In addition, derivatives markets then also increase
savings and long-term investment through the risk-transferring function. In this way, participants in the market can expand
the volume of their activity as a result of the wide variety of choices available.
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Disadvantages
The main disadvantage of the derivatives markets arises from the lack of thorough investigation into how to use
the risk transfer factor. This can result in difficulty when trying to margin transactions, or to monitor various participants’
activities and tailor one’s own activity accordingly.
A lack of thorough research and sound investment may lead to investment losses for which the investor is not
prepared. The risk transfer factor therefore needs to be applied in a targeted way in order to ensure that the investor does
not take unnecessary risks.
Several risks may be involved for those who are not thoroughly familiar with speculative markets. Even though
risks can be transferred, remember that the derivatives market operates on a paradigm of uncertainty. An investor who is not
comfortable with uncertainty in investment might be more comfortable taking on a different type of investment structure.
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Action Checklist
Make sure you have thoroughly investigated your company’s ability to take risks and absorb possible losses if you
decide to participate in the derivatives market.
You must be comfortable with a significant element of speculation.
Seek advice and guidance from the relevant professional experts.
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Dos and Don’ts
Do
Investigate your options in this market thoroughly.
Ensure that you are fully aware of the risks you will be taking, and of what level of risk you are comfortable with.
Make an informed choice, particularly where risk is concerned.
Make sure that you continually review your risk level and modify it if and when necessary.
Don’t
Don’t take unnecessary risks.
Don’t forget to check regularly that you are not exceeding the risk level at which you are comfortable.
Don’t approach the derivatives market with a careless attitude. Make sure that you are always aware of trends and
speculations in the market.
Don’t invest if you are not completely comfortable with participating in a speculative market.
Structured Products: A Further Introduction
Posted by Ian Lowes, June 29, 2011
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Ian Lowes
In 2010 £12.32bn was invested in Structured Products, which, for the right reasons, remained a popular choice with many
advisers; but they’re not all good and IFAs are reportedly only involved in around 25% of the retail market.
Ian Lowes, the Managing Director of Lowes Financial Management, one of the UK’s longest established IFA practices and
creators of StructuredProductReview.com, explains why he believes good advisers and wise investors should consider them
as part of a diversified portfolio.
Structured Products take many guises and as with any investment solution, a good adviser, or an investor with access to the
requisite information, should be able to sort the wheat from the chaff. Whilst they come in a variety of shapes and sizes,
structured products usually have the following features:
• Income or Growth, not usually both
• Defined returns and defined risks
• Linked to a defined measurement such as the FTSE 100
• A defined term, typically of up to 6 years
All such investments are designed to be held until their ultimate maturity date and are dependant upon the issuing institution
or counterparty being able to repay the proceeds at maturity. Whilst there are many counterparties, a significant number of
these investments are backed by the likes of HSBC, Barclays, RBS, Lloyds and the less well known but almost indisputably
stronger Dutch bank, Rabobank.
Essentially, structured products fall into three categories:
• Structured Deposits
These are typically sold by banks and building societies, are designed to return at least the original capital in full at maturity
and potentially benefit from the Financial Services Compensation Scheme (FSCS) protection of up to £85,000 in the event
that the issuer goes bust.
• Capital ‘Protected’ Structured Products
Like Structured deposits, these plans are designed to return the original capital regardless of the how badly the stockmarket
or underlying measure performs but unlike deposits, they will not benefit from FSCS protection if the counterparty defaults.
• Capital at Risk Structured Products
These investments will give rise to a loss at maturity if the underlying index performs poorly over the investment term but
they typically incorporate a ‘barrier’ which protects the capital other than in the event that the stockmarket falls by, say, 50%.
Conversely, by putting the capital at risk these products usually have the potential to produce much higher returns than
capital protected or deposit based plans.
Investment Risk
As Chartered Financial Planners we often utilize the capital at risk variety alongside a portfolio of funds to potentially
enhance or protect the overall returns of the portfolio in both rising and falling market conditions. Whilst less common, we
may also use capital protected and deposit based plans to lower the risk of the portfolio.
But they’re not all good! When these plans became popular in the early part of the last decade some were so dreadful and
risky that we felt we had to warn our clients away from them. As it happened, this particular breed gave rise to horrendous,
unforeseen losses for those who didn’t understand the investment risk. Such contracts have now, effectively, been outlawed.
Other structures that seem like a much safer option have typically been promoted by bank and building society branches to
some customers as an alternative to deposit accounts, but these have often also been very disappointing, producing low
returns. This is of course, in part, a function of the lower the potential risk, the lower the potential return, but it could also be
a result of the profit margin of the distributor being too high. Occasionally, however, there is a good one so don’t dismiss
structured deposits out of hand.
Capital at risk
Capital at risk and ‘protected’ products are, like most investments, only suitable for those who are prepared to expose their
capital to a degree of risk and accept the consequences of the risks resulting in the worst outcome. Such investments are
now numerous and because they are promoted through Independent Financial Advisors they have to be more competitive.
The risks and returns for these investments are very definable and, as such, often represent a good complement to an
investment portfolio.
For example, if, in 2004 you had invested in one of our preferred, six-year capital at risk structured products alongside the
average cautious managed unit trust, the unit trust would have been exposed to the movements of the stockmarket over the
period and produced a gain of approximately 30% including reinvested dividends. The terms of the structured product
provided for a return of 3.5 times any rise in the FTSE 100 index subject to a maximum return of 63%, having protected the
original capital from all but the default of Barclays Bank or the FTSE falling below 2210 points (last seen in February 1991).
Now, a good adviser is unlikely to have constructed such a simple portfolio and so instead of a single cautious managed
fund, they may have used a portfolio of funds alongside a few different structures, but I’m sure you get the point.
Of course, in an ideal world we would have consistent markets and managed funds would provide the perfect solution for
most investors, but markets are anything but consistent and fund performance depends upon the manager’s ability to time
the markets and select appropriate investments and as we know, sometimes, even the best ideas aren’t good enough.
Whilst capital at risk and ‘protected’ structured products have similar initial charges and initial commission / adviser fees as
unit trusts and open ended investment companies (OEICS), the fees in the structured products are taken into account in the
defined terms. So, for example, an investment of £10,000 in a capital ‘protected’ product will provide for adviser
remuneration and in even the most adverse stockmarket conditions, return a minimum of the original investment at the
maturity date of £10,000. Of course the caveat is that should the counterparty underwriting the product go bust the investor
will get nothing and so the investor or adviser has to consider and accept this risk.
For the portfolio
Unlike most managed funds however, structured products do not provide ongoing trail commission and so some advisers
may levy annual portfolio fees.
Investment times are changing and the evolution of the structured product as a mainstream retail investment solution is
testament to this. As I hope I have outlined above, they’re not all the same but the best can be very good additions to a
diversified portfolio. If you think all structured products are the same and you don't give them due consideration, you won't
know what your clients are missing. With this in mind, take a look at StructuredProductReview.com where you can see what
the market has to offer and make up your own mind.
Ian H Lowes
Managing Director
Lowes Financial Management
NOTE: This material is intended for financial services professionals only and should not be construed as advice or
a recommendation to invest.
StructuredProductReview.com is a free, independent service designed by IFAs for IFAs. It aims to make information on the
sector easily accessible to all IFAs, displaying, among other things, information on most of the current products promoted
through IFAs, an archive of matured products, including maturity data and an extensive catalogue of educational material.
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Capital Structure: A Strategy that Makes Sense
by John C. Groth
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Table of contents
Current content: Executive Summary
Current content: Introduction
Issues and Strategy
Managing and Adjusting Capital Structure
Issues Concerning Control
Other Issues
A Recommendation for Capital Structure Strategy
Conclusion, Ideas, and Actions
Summary
Notes
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Executive Summary
Perfect capital markets prescribe an optimal capital structure.
Imperfect capital markets, the seasonal and cyclical aspects of an economy, and the variability of market
conditions argue that a company should have a target capital structure and an operating capital structure range.
Managers should be sensitive to changes in the business risk of a company, as these alter the optimal capital
structure.
Maintaining good debt capacity makes sense and may favorably influence stock price.
Using bad debt capacity does not make sense from the viewpoint of stockholders and primary creditors.
Projects with good economic returns restore debt capacity and reduce the debt/equity (D/E) ratio. Bad projects that
do not have attractive economic returns will have an adverse effect on capital structure, increase the D/E ratio, and
eventually decrease the optimal D/E ratio.
Managers may adjust capital structure quickly or gradually. Whether quickly or gradually hinges on a variety of
factors.
Capital structure is important for privately held firms.
Stock repurchase programs call for sensitivity and possible adjustment of debt capital so that one attains and/or
preserves the desired capital structure.
Leveraged buyouts often distort capital structure. The decision to accept abnormal capital structures originates
with those promoting the buyout and their perceptions about gains relative to personal capital at risk.
Issues related to control may influence the choice of capital structure.
Introduction
Perfect capital markets enjoy an array of assumptions, including no cost to bankruptcy, infinitely divisible financial assets
and liabilities, no transaction costs, etc. Pursuing a selected optimal capital structure would allow minute adjustments, the
issuance or redemption of small amounts of capital, and other conveniences. We would simply strive for the optimal
debt/equity ratio depicted in Figure 1. Indeed, in this unreal world one would keep all the equity for control and to maximize
wealth—and employ massive amounts of debt.1
Imperfect Capital Markets
The rudeness of imperfect markets prompts us to adopt a reasonable strategy that allows one to benefit from the tenets of
capital structure theory while respecting the reality of markets and economies. Imperfect capital markets, bankruptcy costs,
and that a company with financial flexibility may have attractive opportunities during periods of adverse market conditions
argue for a strategy for the management of capital structure. Additionally, capital market participants may value a company
with the financial flexibility that would allow it to pursue opportunities even (or especially) during periods of high market
stress. A company with financial flexibility may find bargains during periods of distress.
In this article we first address background issues. Then we will move to recommendations. We will see that the suggested
strategy does not seek to have the theoretical optimal debt/equity (D/E) ratio.
Good and Bad Debt Capacity
A company that has a less than optimal D/E ratio has unused good capacity. Normally a company with “good” debt capacity
can borrow quickly on favorable terms to pursue an attractive opportunity. Thus, it can obtain capital quickly without the
delays or possible undesirability of an equity offering.
Exceeding the optimal D/E ratio results in the company using “bad” debt capacity. History tells us that it is possible to do
stupid things. Occasionally, we also see agents taking actions that promote their own interests, rather than acting in a way
that benefits owners and creditors. Bad debt capacity adversely affects the weighted cost of capital, limits flexibility, and
decreases stock price
Optimizing the Capital Structure: Finding the Right Balance between Debt and Equity
by Meziane Lasfer
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Table of contents
Executive Summary
Types of Financing
The Irrelevance Proposition
The Trade-Off of Debt
Financing Choices and a Firm’s Life Cycle
Conclusion
Making It Happen
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Executive Summary
Just over 50 years ago Miller and Modigliani (1958) showed that under a certain set of conditions—namely perfect
capital markets with no taxes and agency conflicts—a firm’s capital structure is irrelevant to its valuation.
Their results are controversial and have raised a large number of questions from academics and practitioners.
This article summarizes the main issues underlying the choice by firms of an appropriate capital structure, taking
into account their specific fundamentals as well as macroeconomic factors.
It presents the benefits and costs of borrowing, describes how to assess these to arrive at the basic trade-off
between debt and equity, and examines conditions under which debt becomes irrelevant.
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Types of Financing
There are three financing methods that companies can use: debt, equity, and hybrid securities. This categorization is based
on the main characteristics of the securities.
Debt Financing
Debt financing ranges from simple bank debt to commercial paper and corporate bonds. It is a contractual arrangement
between a company and an investor, whereby the company pays a predetermined claim (or interest) that is not a function of
its operating performance, but which is treated in accounting standards as an expense for tax purposes and is therefore tax-
deductible. The debt has a fixed life and has a priority claim on cash flows in both operating periods and bankruptcy. This is
because interest is paid before the claims to equity holders, and, if the company defaults on interest payments, it will be
declared bankrupt, its assets will be sold, and the amount owed to debt holders will be paid before any payments are made
to equity holders.
Equity Financing
Equity financing includes owners’ equity, venture capital (equity capital provided to a private firm in exchange for a share
ownership of the firm), common equity, and warrants (the right to buy a share of stock in a company at a fixed price during
the life of the warrant). Unlike debt, it is permanent in the company, its claim is residual and does not create a tax advantage
from its payments as dividends are paid after interest and tax, it does not have priority in bankruptcy, and it provides
management control for the owner.
Hybrid Securities
Hybrid securities are securities that share some characteristics with both debt and equity and include, for example,
convertible securities (defined as debt that can be converted into equity at a prespecified date and conversion rate),
preferred stock, and option-linked bonds.
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The Irrelevance Proposition
In 1958 Modigliani and Miller demonstrated that, under a certain set of assumptions, the choice between any of these
securities (referred to as capital structure or leverage) is not relevant to a company’s valuation. The assumptions include: no
taxes, no costs of financial distress, perfect capital markets, no interest rate differentials, no agency costs (rationality), and
no transaction costs. These assumptions are, in fact, the main drivers of capital structure and gave rise to the trade-off
theory of leverage.
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The Trade-Off of Debt
In this so-called Miller–Modigliani framework, firms choose their optimal level of leverage by weighing the following benefits
and costs of debt financing.
Benefits of Debt
There are two main advantages of debt financing: taxation, and added discipline.
Taxation: Since the interest on debt is paid before taxation, whereas dividends paid to equity holders are usually paid from
profit after tax, the cost of debt is substantially less than the cost of equity. This tax-deductibility of interest makes debt
financing attractive. Suppose that the debt of a company is $100 million and the interest rate is 10%. Every year the
company pays interest of $10 million. Suppose that the corporation tax rate is 30%. If the company does not pay tax, its
interest will be $10 million and the cost of debt will be 10%. However, if the company is able to deduct the tax on this $10
million from its corporation tax payment, then the company saves $10 million × 30% = $3 million in tax payments per year,
making the effective interest payment only $7 million. If the debt is permanent, every year the company will have a $3 million
tax saving, referred to as a tax shield. We can compute the present value (PV) by discounting annual value by the cost of
debt, as follows:
PV of tax shield = kd × D × tc ÷ kd = D × tc
where kd is the cost of debt, D is the amount of debt, and the product of kd and D gives the amount of the interest charge. tc
is the corporation tax rate. We simplify the ratio by kd to obtain the present value of the tax shield as the product of the
amount of debt and the corporation tax rate. Thus, the value of a company that is financed with debt and equity (such a
company is referred to “levered”) should be equal to its value if it is financed only with equity plus the present value of the
tax shield. We can write this value as:
Value of levered firm with debt D = Value of nonlevered firm + D × tc
These arguments suggest that the after-tax cost of debt can be computed as 10% × (1 − 30%) = 7%.
Added discipline: In practice, the managers are not the owners of the company. This so-called separation of managers and
stockholders raises the possibility that managers may prefer to maximize their own wealth rather that of the stockholders.
This is referred to as the agency conflict. In general, debt may make managers more disciplined because debt requires a
fixed payment of interest, and defaulting on such payments will lead a company to bankruptcy.
Costs of Debt
Debt has a number of disadvantages, including a higher probability of bankruptcy, an increase in the agency conflicts
between managers and bondholders, loss of future financial flexibility, and the cost of information asymmetry.
Expected bankruptcy cost. Given that debt holders can declare a company bankrupt if it defaults on its interest payment,
companies that have a high level of debt are likely to have a high probability of facing such a default. This probability is also
increased when a company is operating in a high business risk environment. Debt financing creates financial risk. Thus,
companies that have high business risk should not increase their risk of default by taking on a high financial risk through
their use of debt. Evidence indicates that much of the loss of value occurs not in the liquidation process but in the stage of
financial distress, when the firm is struggling to pay its bills (including interest), even though it may not go on to be
liquidated.
Agency costs: These costs arise when a company borrows funds and the managers use the funds to finance alternative,
usually more risky, activities than those specified in the borrowing contract to generate higher returns to stockholders. The
greater the separation between managers and lenders, the higher the agency costs.
Loss of future financing flexibility: When a firm increases its debt substantially, it faces difficulties raising additional debt.
Companies that can forecast their future financing needs accurately can plan their financing better and may not raise
additional funds randomly. In general, the greater the uncertainty about future financing needs, the higher the costs.
Information asymmetry: When companies do not disclose information to the market, their information asymmetry will be
high, resulting in a higher cost of debt financing.
Redeployable assets of debt: Lenders require some sort of security when they fund a company. This security is referred to
as collateral. Lenders accept assets that can be resold or redeployed into other activities, such as property (real estate), as
collateral. In general, the lower the value of the redeployable assets of debt, the higher are the costs.
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Financing Choices and a Firm’s Life Cycle
Although companies may prefer to use internal financing to minimize the issuance (transaction) costs, the trend in financing
depends critically on the firm’s life cycle.
Start-ups are small, privately owned companies. They are likely to be financed by owners’ funds and bank borrowings. Their
funding needs are high, but their ability to raise external funding is limited because they do not have sufficient assets to offer
as security to finance providers. They will try to seek private equity funding. Their long-term leverage is likely to be low as
they are mainly financed with short-term debt.
Expanding companies are those that have succeeded in attracting customers and establishing a presence in the market.
They are likely to be financed by private equity and/or venture capital in addition to owners’ equity and bank debt. Their level
of debt is low and they have more short-term than long-term debt in their capital structure.
High-growth companies are likely to be publicly traded, with rapidly growing revenues. They will issue equity in the form of
common stock, warrants, and other equity options, and probably convertible debt. They are likely to have a moderate
leverage.
Mature companies are likely to finance their activities by internal financing, debt, and equity. Their leverage is likely to be
relatively high but will depend on the costs and benefits of debt and their fundamental factors, such as business risk and
taxation.
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Conclusion
This article discussed the different financing methods companies can use and then argued that their choice depends on the
costs and benefits of debt financing and the firm’s life cycle. For example, whereas start-up companies are likely to be
financed with private personal funds, making their leverage low, mature companies tend to have high leverage because they
are able to mitigate the costs of debt and gain from the tax benefits. In addition to these factors, in practice firms may
choose their financing mix by mimicking comparable firms, or they may adopt the average level of debt of all the companies
in their industry. These methods are not highly recommendable as they may result in a suboptimal choice. In other cases
they follow a financing hierarchy, where retained earnings are the preferred option, followed by external financing in the form
of debt, and then equity. This preference is driven by the transaction and monitoring costs.
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Making It Happen
The choice of financing is strategic and involves the following issues:
Both low- and high-debt financing are suboptimal. Companies should aim for the most advantageous level of debt
financing, whereby the costs are minimized and the benefits are maximized.
The costs of debt include a greater probability of bankruptcy, an increase in the agency conflicts between
managers and bondholders, a loss of future financial flexibility (including the availability of collateral assets), and information
asymmetry costs.
The benefits relate mainly to tax shields and the added discipline to mitigate the agency conflicts between
stockholders and managers.
This equilibrium applies primarily to mature companies. Start-ups and growth companies are likely to have lower
leverage as their borrowing capacity is low. It also applies to companies that normally pay dividends and do not accumulate
cash for reinvestment in order to avoid the need to raise external financing.
The recent financial crisis has highlighted another issue in debt financing, namely liquidity. Leverage concepts
were developed mainly in times when debt financing was fully available. In the current credit crisis this is no longer the case.
Companies therefore now have to pay an extra liquidity cost to raise additional capital. The question is whether this is a
temporary situation or a permanent one, in which case debt will become more costly and leverage will be lower than in the
past.
Another challenge of debt financing relates to the ethics of the use of excessive debt financing, particularly by
financial institutions. Pettifor (2006) was able to foresee the current crisis, tracing debt financing back to early times and
arguing that religions are against debt because it results in usury. She provides interesting arguments, challenging the whole
structure of debt financing, payment of interest, and interest tax deductibility. Possibly a new structure of debt that is linked
to the profitability of assets and incurs no interest will emerge from the current crisis.
Capital Structure: Perspectives
by John C. Groth
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Table of contents
Executive Summary
Introduction
Capital Structure
Tax-Deductible Interest
Behavior of Weighted Cost of Capital
Other Issues
Conclusion
Making It Happen
Notes
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Executive Summary
Capital structure reflects the financing strategy and potentially influences the value of a company.
The potential value to shareholders of capital structure depends on the tax environment.
Understanding the logic of capital structure and the origin of potential value is of import to leaders, strategists, and managers.
The greater the business risk, the lower the optimal debt/equity (D/E) ratio.
Tax strategy and management should consider capital structure. The higher the expected tax rate, the more important are capital structure decisions and management.
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Introduction
Capital has three forms: human, tangible, and financial. In this article, we focus on how financing choices influence the cost of financial capital and company value. Capital structure focuses on the sources of financial capital. The choice of structure affects firm value in some economies.1
The seminal works of Nobel laureate Franco Modigliani conceived important relationships and issues in capital structure. Subsequently, researchers have nourished the development of capital structure theory and the related literature, and they have influenced practice. Many companies follow the prescriptions of capital structure theory, and create value for stockholders and society.2
We do not have the “perfect” capital markets described by economists, and key factors influence the choice of capital structure. For example, investors are concerned with the potential for, and cost of, bankruptcy. If a company disappoints investors by using too little or too much debt, its stock price will suffer. Understanding exactly how the use of some debt may add to company value is essential to understanding capital structure.
First, we will clarify the meaning of capital structure. Then we will address other issues.
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Capital Structure
The decision on capital structure is the choice of how to finance a company. Capital structure represents the proportion of each source of financing relative to total financing. Types of financing fall into broad categories: equity, representing ownership; debt; and preferred financing. Interestingly, in some economies the concept of equity or ownership was unfamiliar until recently, as historically individuals did not enjoy the privilege of ownership.
Capital structure is about dividing up expected economic returns (not accounting returns) and risk, in exchange for providing capital. Those divisions are specific. For example, a pecking order exists amongst the different creditors. The “covenants” of debt arrangements, as well as precedent in practice and legal arrangements, address these relationships. For example, in practice “normal” trade credit is often not formalized, and the company routinely pays trade creditors.3
In the context of capital structure and an “ongoing enterprise,” equity ownership is last in line with a claim on what others have not claimed of the returns. Equity holders also bear the risks which the creditors and preferred shareholders (if present) have not accepted. In the event of financial distress or bankruptcy, in most economies very specific rules apply to dividing up the carcass.4
In Figure 1, the balance sheet depicts the “assets” and the source of financing, and, consequently, the claim on the assets. For simplicity, we will focus on financing with a combination of debt and equity, ignoring preferred shares as a source of capital. In fact, many firms do not have preferred shares.
Figure 1. Alternative capital structures
The choice of assets, how well we manage the assets, and the nature and success of our providing product/services to markets, taxes, and other factors determine the business risk of the company. The business risk influences the cost of equity capital. For a firm without debt, or an “unlevered” firm, the cost of equity equals the risk-free rate of interest plus a premium for business risk. Collectively, the business risk factors will determine the expected level and risk of cash flows that originate in the asset side of the company. These expected cash flows that come from the asset side of the company must service any debt. After debt service and the payment of taxes, the net remaining cash flows provide the expected returns to equity holders.
The higher the business risk of a company—and hence, the greater the uncertainty in cash flows from the asset side of the business—the less financial risk a company should have, and the lower the optimal D/E ratio.
Consequently, the more uncertain the environment, and the greater the sensitivity of the business side of the company to the economic environment, the more important it is that one select a capital structure with care. Companies with high sensitivity to the cyclical effects of the economy should consider a more conservative capital structure, and have a strategy to manage the structure across economic cycles.
For the purposes of discussion, Figure 1 shows four alternative financing arrangements. In financing alternative A, only equity holders provide capital. In finance jargon, situation A represents an unlevered firm. Each equity holder has a claim on the after-tax benefits of owning and operating the assets, as well as on the assets themselves. The proportion of total shares owned determines the claims of each. In some instances, different classes of equity exist, with the rights of each class defined accordingly.
Alternatives B and C represent different ways of financing the same assets, with C having a higher debt/equity ratio than B. Assuming that the nature of liabilities (discussed shortly) for B and C are the same, C, which has the higher debt/equity ratio, has greater financial risk. We will explain alternative D later in the chapter.
Relative Position and Risk
Capital structure does not involve sharing, but dividing and ordering. Deciding to use debt and/or preferred ownership entails dividing expected returns and risk, and ordering claims—both for “normal” times, as well as in the event of bankruptcy. Think of a line of people, an uncertain future, and expected benefits that may stem from the operation or sale of a company’s assets, or benefits that might arise from the financing of the company.
A metaphor helps in understanding the issues and relationships. Imagine an apple orchard. Uncertainty exists about future crops in terms of the size, and quality, of the apples. Variance in quality means not all apples in a crop have equal value. Let’s see how the ordered line works.
Governments are first in line, taking the most certain and best apples for taxes. Some taxes are ardent claims, which are due independent of the sufficiency of the crop. Equity holders bear this tax responsibility. However, tax circumstances also affect creditors and other providers of capital.
Fundamental Principle: The Division of Risk and Expected Return
A position first in line gives first access to the orchard, and the right to take the best apples. Others enter the orchard according to their order in the line, each taking the apples they are allowed—if apples are available. The average quality of the remaining apples declines with the successive removal of the best of the remaining crop, as those in line are careful and claim the best apples to which they are entitled. Remove the best, and the quality of what remains must be lower—and the risk that insufficient or no apples remain increases.
After the tax authorities, creditors are next in line, with multiple creditors each careful to specify and protect their position in the line. Sometimes creditors limit the number and/or magnitude of other credit claims in line. Preferred stockholders (if the company has any) have a position in line ahead of common stockholders, but behind creditors. A company may have different classes of stockholders, with the classes also ordered.
Equity holders are last in line, expecting to get the lower-quality (higher-risk) apples that are left, and having a claim on all that are left. Equity holders, last in line, have the most risk, but also the possibility of unlimited returns. Equity holders bear the risk that others have not accepted, and they get what is left over. Different classes of equity holders may exist, with these classes differentiated and “labeled,” for example, class A. The classification scheme specifies the positions, potential rights, and claims of each class.
With distress or bankruptcy, the provisions of the various sources of financing specify the relative position and claims of each party, but with one usual modification: tax liabilities, attorneys, and related costs often take first from the carcass. After that, an ordered picking over the corpse follows.
Motivation for Using Debt
A logical question surfaces: why would equity holders allow others to go ahead of them in the line? There are two main reasons for this: garnering incremental value; and/or issues of control.
Increased Value
Potential increases in value stem from “leveraging effects” (stockholders) and tax effects (total firm value). Capital structure theory generally focuses on the value that may originate in tax effects that result from the use of debt. This article focuses on capital structure, but we will first briefly comment on the classic financial leverage reasons for using debt.
Equally Clever Creditors and Stockholders Have Implications
The presence of astute creditors and stockholders will result in no bargains or favors in terms of dividing up expected returns and risks. Creditors will not give stockholders a bargain just to be nice. Absent control issues, capital structure is only important if interest on debt is tax-deductible, and dividend payments are not deductible.
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Tax-Deductible Interest
In some economies, interest is tax-deductible. The expected deductibility of interest payments provides opportunity for value. The expected benefit of this deduction flows to stockholders, which is best illustrated with an example.
Example
A company borrows money at a fixed rate of 10%. The tax rate is 30%. The company expects to have sufficient pretax income to allow the deduction of the interest before calculating taxes. The net effects are:
Lenders expect payment of 10%, whether the company has taxable income or not.
If the company realizes the tax deduction, the after-tax cost = 10% (1 − 0.3) = 7%.
The expected benefit of the tax deduction goes to stockholders.
The stockholders have increased financial risk that stems from the borrowing—and letting creditors precede them in line.
Stockholders are astute. Increased risk increases the cost of equity capital.
However, if the expected value of the tax savings is attractive to stockholders relative to the added risk of borrowing, stockholders are happy, and the share price increases.
The right choice of capital structure will result in a reduction of the weighted cost of capital—even though the cost of both equity and debt capital increase with debt, as Table 1 illustrates, and we discuss below.
Importantly, the tax deduction and its benefit is an expected benefit, as the uncertain pretax income (EBIT or NOI in several economies) must be large enough to allow the interest deduction.
Tax Rate and Implications
Notice that the higher the tax rate, the greater the potential impact of the deductibility of interest on the after-tax cost of debt. For example, with the same 10% borrowing rate but a 40% tax rate, the after-tax cost is 10% (1 − 0.4) = 6%.
We take care not to confuse issues. We don’t benefit from higher tax rates. However, the higher the tax rate we endure, the more important becomes the choice of capital structure.
To reiterate, the tax benefits of using debt do not alter the promised cash flows in the form of interest or principle to creditors. Any tax benefits therefore precipitate to stockholders, and that is core to understanding how capital structure can create value.5
Asymmetry of Effects
The use of some debt in place of some equity will lever up (down) the expected returns to stockholders. If interest is tax-deductible, the potential good or bad leveraging effects are asymmetric. If the company has returns on its assets that exceed the cost of debt, a positive leveraging effect accrues to stockholders. If stockholders view these returns as attractive, given the financial risk of the added debt, the stock value increases.
If the EBIT for tax accounting is insufficient to allow the deduction of interest, stockholders must now bear the full cost of debt rather than benefit from a lower after-tax cost.6 This shift in tax impact results in a greater and adverse leveraging effect on returns to stockholders, as equity investors must now cover the full cost of debt, rather than the after-tax cost of debt. Using the original example above, the cost of debt rises from the after-tax 7% to the full 10%. The inability to realize the interest deduction results in an asymmetric effect on expected returns to stockholders.
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Behavior of Weighted Cost of Capital
An example showing the behavior of the component costs of capital and the weighted cost of capital (WCOC) appears in Table 1. For simplification, we consider only equity and debt sources of capital. One might employ one or more models, or different forms of models, as well as alternative econometric procedures to estimate the costs of the components of capital for different levels of leverage.7
Table 1. Calculation of weighted cost of capital (WCOC)
Source of capital
Relative proportion
Cost of component
Weighted cost of component
Weighted cost of captial
Debt 0% 5.40% 0.00%
Equity 100% 13.00% 13.00%
13.00%
Debt 10% 5.40% 0.54%
Equity 90% 13.40% 12.10%
12.64%
Debt 20% 6.10% 1.22%
Equity 80% 13.90% 11.12%
12.34%
Debt 30% 6.60% 1.98%
Equity 70% 14.50% 10.15%
12.13%
Debt 40% 7.60% 3.04%
Equity 60% 15.50% 9.30%
12.34%
Debt 50% 9.00% 4.50%
Equity 50% 17.20% 8.60%
13.10%
Entries reflect the raising of money from debt and equity in different proportions. The more debt that is used as a proportion of the total, the less equity (and fewer shares). Costs are after-tax costs to the company. The cost of debt represents the weighted cost of debt, reflecting the fact that first-in-line creditors have lower risk, and the borrowing cost is lower. Creditors that follow in line have greater risk, and demand a higher rate. The chapter, “The Weighted Cost of Capital: Perspectives and Applications,” addresses issues related to the WCOC.
For all entries in this table, the company is getting the same amount of money. The values show the effects of getting this money in different proportions from debt and equity, which is the capital structure decision.
Choices of capital structure seek to increase the value of the firm. Hence, in Table 1 and all discussion in this chapter and the chapter, Capital Structure: A Strategy that Makes Sense, debt and equity refer to the market values of debt and equity. Hence, the D/E ratio we calculate uses the market values of the debt and equity.
Note in Table 1 that the weighted cost of capital (WCOC) at first decreases, reaching a minimum when about 30% of capital comes from debt and 70% from equity. Observe also that this decrease occurs even though the weighted cost of debt increases with the use of an increased proportion of debt capital. Recognize that successive increments of debt cost more, as successive creditors in the line of claimants demand higher expected returns to compensate for their higher risk.
With an increase in the use of debt, the cost of equity increases as well. Equity holders recognize the greater financial risk attendant with a higher D/E ratio, and demand increased expected returns.
Seemingly, the WCOC could not decline if the cost of components increased. The reason for the decline stems entirely from the expected tax-deductibility of debt, and equity holders think the value of the tax
benefit is attractive compared to the added risk. As the D/E ratio increases, the amount of equity decreases because we are raising the same amount of capital everywhere in Table 1. If we raise more from debt, less comes from equity. The use of some debt rather than all equity amplifies the effect on a per-share basis, as the company needs fewer shares for the same amount of capital. The result is that with an increasing D/E the expected tax benefits increase, and these are spread over fewer shares.
In the example in Table 1, note that obtaining more than 30% of capital from debt results in an increase in the WCOC. Above 30% debt, stockholders do not think that the incremental tax benefits of more debt are attractive enough to compensate them for the incremental financial risk, and the uncertainty of realizing the tax benefits. Hence, the demanded rate of increase in the cost of equity and debt overpowers the effects on value of the expected incremental tax benefits of employing more debt.
Summary
Given a particular business risk of a company, determined by the asset side of the business and how well the company employs its assets, an optimal capital structure exists—optimal, as it lowers the WCOC of the company. For example, in Table 1, using about 30% from debt and 70% from equity will result in the lowest weighted cost of capital.8 Note in the table that the cost of components increases in a nonlinear manner as the use of debt increases. This behavior is related to several factors, including: the risk of realizing the expected tax benefit of debt; potential distress caused by excess debt, and its effects on operations as well as opportunities and investments; and possible bankruptcy with attendant loss.
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Other Issues
The Nature of Liabilities and Optimal D/E
The nature of the liabilities influences the choice of capital structure. Let alternative D in Figure 1 represent the same capital structure as in alternative C. Suppose that certain characteristics of the liabilities for C and D differ. To illustrate, assume that the weighted maturity of liabilities in D is less than that in C, and/or that C represents borrowing at a fixed rate while some debt in D has a variable rate of interest.
Despite the same D/E ratio, the financial risk of D is greater than that of C because D is bearing interest-rate risk if the debt has a variable rate of interest, and D has more risk as it faces refunding of debt sooner. Less flexibility in the timing of refunding the debt is a potentially important issue, as capital market conditions vary over time. The developments and difficulty for firms of obtaining “replacement” credit in the 2008 crisis illustrate this refunding risk.
Logically, the nature of the liabilities therefore affects the optimal D/E ratio. For A, B, C, and D, the business risk is still the same. The use of liabilities with greater risk (in this scenario, maturity and interest rate risk) results in a lower optimal D/E, despite the same business risk on the asset side of the company. Thus, if the structure shown for C is optimal, the structure shown for D is incorrect. D should
have a lower optimal D/E ratio than C, as the nature and structure of liabilities for D results in higher risk on the financing side of the company.
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Conclusion
The tax deductibility of interest provides the opportunity to add to company value by employing the correct amount of debt relative to equity. The underlying relationships that cause this potential increment in value rest on the logical behavior of informed investors who agree to divide risks and expected returns. The deductibility of interest has expected economic benefits that flow to equity holders. Consequently, the use of debt is logical if interest is tax deductible and we expect to realize the benefit of that deduction. The higher the corporate tax rate we must endure, the greater the value of issuing debt.
The choice of how to finance the company, and its resulting debt/equity ratio, is the capital structure decision. Issues relating to the strategy and management of capital structure are discussed in the article, Capital Structure: A Strategy that Makes Sense.
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Making It Happen
Remember that the expected tax deductibility of interest is the origin of any value that arises from the choice of capital structure.
In capital structure decisions, the examination focuses on the market value of debt and equity.
Changes in the tax rate will influence the optimal capital structure.
The greater the business risk, the lower the optimal D/E ratio.
The choice of capital structure will influence the cost of the individual sources of capital, and, in turn, the weighted cost of capital.
“Real world” considerations argue for a target capital structure, and a strategy to pursue that structure. The chapter, “Capital Structure: A Strategy that Makes Sense,” examines these issues and offers guidance on a strategy.
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Notes
1 Issues of control can influence choice of capital structure, for example, with current managers not willing to issue equity as the issuance would dilute management’s “personal” control percentage, or alter the distribution of shares in float.
2 Actions that lower the cost of capital result in benefits to individuals in economies and societies. In contrast, in 2008 we have witnessed the adverse and spreading effects that result from interruptions in the availability and/or cost of capital in economies.
3 If suppliers perceive unnecessary risk or the likelihood of financial distress, suppliers may demand trade notes payable. Trade notes payable formalize trade credit, and seek to clearly identify the obligation. Hence, requiring formalization of obligation with trade notes payable clarifies as well as “perfects” the supplier’s interest, and relative claimant position. This formalization can alter the risks to the suppliers of receipt of payment, both during ongoing operations as well as in the case of bankruptcy. Normally, the existence of trade notes payable on a balance sheet signals concerns by trade creditors of the financial viability of the company.
4 Multiple classes of equity may exist, with specified relative claimant positions during normal operations as well as in bankruptcy.
5 In imperfect markets with multiple periods, and with certain tax rules, the risk of promised cash flows to creditors may be reduced by the tax-deductibility of interest in previous periods or by carry-back tax effects. These issues are beyond the scope of this article.
6 In some environments, differences exist in accounting for taxes, and accounting for financial reporting.
7 The most common approaches include several different model forms based on the capital asset pricing model, multi-factor models, discounted cash flow models, risk-premium models, and other pricing models.
8 This is an approximation. Estimating the WCOC curve and finding the minimum point is not a precise science.
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Further reading
Current tab: Articles:
Website:
Articles:
Groth, John C., and Ronald C. Anderson. “Capital structure: Perspectives for managers.” Management Decision 35:7 (1997): 552–561. Online at: dx.doi.org/10.1108/00251749710170529
Miller, Merton H. “The Modigliani–Miller propositions after thirty years.” Journal of Applied Corporate Finance 2:1 (Spring 1989): 6–18. Online at: dx.doi.org/10.1111/j.1745-6622.1989.tb00548.x
Debt/Equity Ratio
Debt/equity is the most commonly used method of assessing corporate debt, but in fact there is more than one way of
expressing essentially the same thing.
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What It Measures
How much money a company owes compared with how much money it has invested in it by principal owners and
stockholders.
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Why It Is Important
The debt/equity ratio reveals the proportion of debt and equity a company is using to finance its business. It also measures a
company’s borrowing capacity. The higher the ratio, the greater the proportion of debt—but also the greater the risk.
Some even describe the debt/equity ratio as “a great financial test” of long-term corporate health, because debt establishes
a commitment to repay money throughout a period of time, even though there is no assurance that sufficient cash will be
generated to meet that commitment.
Creditors and lenders, understandably, rely heavily on the ratio to evaluate borrowers.
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How It Works in Practice
The debt/equity ratio is calculated by dividing debt by owners’ equity, where equity is, typically, the figure stated for the
preceding calendar or fiscal year. Debt, however, can be defined either as long-term debt only, or as total liabilities, which
include both long- and short-term debt.
The most common formula for the ratio is:
Debt/equity ratio = Total liabilities ÷ Owners’ equity
In our example, a company’s long-term debt is $8,000,000, its short-term debt is $4,000,000, and owners’ equity totals
$9,000,000. The debt/equity ratio would therefore be (calculating in thousands):
(8,000 + 4,000) ÷ 9,000 = 12,000 ÷ 9,000
= 1.33
An alternative debt/equity formula considers only long-term liabilities in the equation. Accordingly:
8,000 ÷ 9,000 = 0.889
There is also a third method, which is the reciprocal of the debt-to-capital ratio; its formula is:
Debt/equity ratio = Owners’ equity ÷ Total funds
However, this would be more accurately defined as “equity/debt ratio.”
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Tricks of the Trade
It is important to understand exactly how debt is defined in the ratio presented.
When calculating the ratio, some prefer to use the market value of debt and equity rather than the book value,
since book value often understates current value.
For this ratio, a low number indicates better financial stability than a high one; if the ratio is high, a company could
be at risk, especially if interest rates are rising.
A ratio greater than one means assets are mainly financed with debt; less than one means equity provides most of
the financing. Since a higher ratio generally means that a company has been aggressive in financing its growth with debt,
volatile earnings can result owing to the additional cost of interest.
Debt/equity ratio is somewhat industry-specific, and often depends on the amount of capital investment required.
Understanding Capital Structure Theory: Modigliani and Miller
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This checklist describes the Modigliani–Miller theorem of capital structure, devised by Franco Modigliani and Merton Miller in
1958, which set out the cornerstones for modern thinking on capital structure and corporate finance.
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Definition
The Modigliani–Miller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an
efficient market, a company’s value is unaffected by how it is financed, regardless of whether the company’s capital consists
of equities or debt, or a combination of these, or what the dividend policy is. The theorem is also known as the capital
structure irrelevance principle.
A number of principles underlie the theorem, which holds under the assumption of both taxation and no taxation. The two
most important principles are that, first, if there are no taxes, increasing leverage brings no benefits in terms of value
creation, and second, that where there are taxes, such benefits, by way of an interest tax shield, accrue when leverage is
introduced and/or increased.
The theorem compares two companies—one unlevered (i.e. financed purely by equity) and the other levered (i.e. financed
partly by equity and partly by debt)—and states that if they are identical in every other way the value of the two companies is
the same.
As an illustration of why this must be true, suppose that an investor is considering buying one of either an unlevered
company or a levered company. The investor could purchase the shares of the levered company, or purchase the shares of
the unlevered company and borrow an equivalent sum of money to that borrowed by the levered company. In either case,
the return on investment would be identical. Thus, the price of the levered company must be the same as the price of the
unlevered company minus the borrowed sum of money, which is the value of the levered company’s debt. There is an
implicit assumption that the investor’s cost of borrowing money is the same as that of the levered company, which is not
necessarily true in the presence of asymmetric information or in the absence of efficient markets. For a company that has
risky debt, as the ratio of debt to equity increases the weighted average cost of capital remains constant, but there is a
higher required return on equity because of the higher risk involved for equity-holders in a company with debt.
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Advantages
In practice, it’s fair to say that none of the assumptions are met in the real world, but what the theorem teaches is
that capital structure is important because one or more of the assumptions will be violated. By applying the theorem’s
equations, economists can find the determinants of optimal capital structure and see how those factors might affect optimal
capital structure.
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Disadvantages
Modigliani and Miller’s theorem, which justifies almost unlimited financial leverage, has been used to boost
economic and financial activities. However, its use also resulted in increased complexity, lack of transparency, and higher
risk and uncertainty in those activities. The global financial crisis of 2008, which saw a number of highly leveraged
investment banks fail, has been in part attributed to excessive leverage ratios.
Investors and the Capital Structure
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Checklist Description
This checklist provides an overview of the capital structure and offers a brief snapshot of the factors behind companies’
choices of capital structure.
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Definition
A company’s capital structure is determined by its long-term financing arrangements, including a combination of common
stock, debentures, preferred stock, long-term debt, and retained earnings. The capital structure, which is also known as the
capitalization structure, differs from the financial structure in that the latter reflects short-term liabilities and accounts
payable.
To better understand the nature of a company’s capital structure, it is worth considering the comparative levels of equity and
debt. Companies with relatively high levels of debt are said to have higher “gearing.” However, a company’s gearing outlook
is not always as simple as it may appear at first glance. Convertible bonds, for example, are classed as debt at the time of
issue but could subsequently become equity. Conversely, preference shares are by nature equity, but they have a fixed-
return element that gives them certain debt-like characteristics.
At a simplistic level, a company’s choice of capital structure should have no impact on the company’s total value, as
represented by the sum of equity and debt. This theory is sometimes known as “capital structure irrelevance” or the
“Modigliani–Miller theory.” Promulgated in the 1960s by Franco Modigliani and Merton Miller, who later collected the Nobel
Prize for Economics, the basis of the theory is that all investors in the company ultimately benefit from the total cash flows
enjoyed by the company. Changes to the overall balance between equity and debt have no effect on the cash flows, only on
how they are effectively divided up between different types of investor. However, more advanced financial models
subsequently demonstrated the limitations first recognized by Modigliani and Miller: factors of relevance include the impact
of taxation and agency issues, i.e. conflicts of interests between executives, equity investors, and bondholders.
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Advantages
A basic understanding of a company’s capital structure, particularly its level of gearing, is a useful starting point
when considering an investment in the company.
Investors in companies with capital structures based on equity would expect to receive returns on their investment
via dividends. Capital growth is also likely when the company is performing well. However, one advantage of this structure
from the company’s perspective is that payment of dividends is optional, giving the company the right to make no dividend
payments during challenging trading periods.
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Disadvantages
A company with a capital structure based largely on debt is required to pay interest to the debt holders, regardless
of how the company is performing. However, there may be tax advantages associated with debt repayments.
Careful thought needs to be given to capital-structure decisions, based on factors such as expected rate of
investment return and cost of capital. Ill-judged capital-structure decisions can lead to serious financial problems.
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Action Checklist
Be clear about the differences between capital structure and financial structure—terms that are often confused.
Capital structure is the equity/debt balance of a company’s long-term finances, whereas financial structure also includes
short-term funding arrangements, as represented in the current liabilities on the company’s balance sheet.
Aim to understand the factors behind companies’ choice of capital structure. There are many considerations
behind these decisions, including cash flow projections, possible taxation benefits, funding availability, industry factors, risk
considerations, and cash management.
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Dos and Don’ts
Do
Consider the benefits of buying a combination of shares and debt when making an investment in a company. This
approach would effectively lower the gearing of the investment opportunity relative to a shares-only purchase.
Bear in mind that, while differences between rival companies’ capital structures can seem significant, research
based on extensions of the Modigliani–Miller theory has suggested that the benefits of adjustments to companies’ capital
structures are frequently limited.
Don’t
Don’t ignore a company simply because of its capital structure. An investor looking for a more highly geared
proposition could buy shares in the company, then lend against them.
Don’t ignore the possible impact of agency problems when analyzing companies. Conflicts of interest can occur in
many forms, even between stockholders, debt holders, and executives.
Lehman Bros: The auditor’s dilemma, part 1
Posted by Anthony Harrington, March 22, 2010
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Anthony Harrington
This is the second of a series of QFINANCE blog posts on the Anton Valukas’s report on the collapse of Lehman Brothers.
See also: Time for Sarbox to be rethought post-Valukas, by Ian Fraser; Just an accounting gimmick? by Anthony Harrington;
and Repo 105, the case for the defense by Anthony Harrington.
According to Anton Valukas, the examiner appointed to look into the demise of Lehman Brothers, there are “colourable”
claims against Lehman’s auditors, Ernst & Young, for allowing the company to “window dress” its accounts using a
technique that removed over $50 billion in leveraged debt off Lehmans’ balance sheet for just long enough for it to present
its quarter end accounts—a trick it pulled off at least three times in the period before its abrupt demise (for a detailed
account of Repo 105 and Repo 108 transactions see part 2).
Since senior Lehman staff have told Valukas in no uncertain terms that there was “no substance” to these transactions and
that their sole purpose was to present an edited and therefore “untrue and unfair” picture of Lehman’s position, the obvious
question is: how did this get past the external auditors?
The UK Financial Reporting Council (FRC) was apparently sufficiently disturbed by Valukas’s comments concerning Ernst &
Young’s audit of Lehman, to invite the firm in to explain its thinking regarding the Repo 105 transactions.
E&Y’s response to date has been to issue a statement reminding everyone that its last audit of Lehman was for the 2007
accounts and Lehman in fact failed in September 2008, long before E&Y had got into its stride auditing the relevant set of
accounts for 2008. It states quite categorically that in its view the 2007 accounts were tickety boo, or in audit parlance “true
and fair,” and 2008 with all it entailed was, well, not its problem since it had not yet had a chance to pronounce on the 2008
figures.
Given that E&Y picked up $31 million for auditing Lehman in 2007 and was reappointed as its auditor in 2008 this is not
likely to be a position that attracts too much sympathy. Whether it will stand rigorous testing in any subsequent court action
is now the key question. As one commentator remarked, mulling over the implications of this fiasco: “The real danger here is
that the audit profession will make itself redundant.” What’s the point of an umpire if they hand the rule book over to the
players?
Others have asked whether Lehman Brothers could turn out to be E&Y’s Enron, a reference to Arthur Andersen, once a
leading big five audit firm, which imploded after the Enron scandal. None of this shows in E&Y’s calm statement, nor in its
only public response to the FRC’s invitation, namely that it will “cooperate with anyone” on Lehman.
What seems plain is that Repo 105 (again see part 2 for a detailed explanation) is a legal technique in London, though not in
New York. In London a Repo 105 transaction constitutes a sale, rather than a loan collateralized with assets. Technically,
therefore, there is no obligation on the “seller” (borrower, in reality, since Lehman is turning long-term assets into current
cash through the Repo 105 transaction) to record the fact in its books that it has a very real and present obligation to reverse
the transaction in very short order. That just conveniently drops out of the book-keeping.
That this is hogwash should be plain as the nose on an auditor’s face. But the point, and it is not a trivial point, is that the
hogwash in question is legal in London’s oh-so-light-touch regulatory regime. The auditor can therefore look at the
transaction, scratch his or her head and say, “hey, that looks funny, but it’s legal in the forum in which it is being deployed,
and besides, if we stamp on it, our client—the one who is paying us $31 million—will look very much more leveraged and
exposed than they currently look. So what to do?” This is all speculation, of course. We do not actually know what reasoning
E&Y adopted in considering these transactions, since the firm hasn’t yet “come clean” on its thinking here.
What is abundantly clear, however, is that E&Y is in a very different position, with respect to these transactions, following the
Lehman Brothers failure, than it would have been in had Lehman been bailed out along with all the other failed US banks.
From that standpoint E&Y’s judgment looks like a gamble that didn’t pay off. Quite what the fallout is going to be is at
present very unclear, but what the firm has succeeded in doing is in demonstrating that the drive to prevent financial service
companies and corporates generally from window dressing their accounts—a drive that built up quite a head of steam in the
1980s—still has a very long way to run in 2010.
Further reading for external auditing
Viewpoint: Aldo Mareuse , The Evolving Role of the CFO
Viewpoint: Sir John Stuttard 2 , Ethics and Finance
Viewpoint: Jim Rogers , Asia: Future Perspectives
Lehman Bros: Time for Sarbox to be rethought post-Valukas , by Ian Fraser [blog post]
Hedging Credit Risk—Case Studies and Strategies
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Checklist
This checklist examines credit risk and the instruments that may be used as hedges to reduce exposure.
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Definition
Credit risk is the uncertainty about the ability of a debtor or the counterparty in an agreement to make a payment. Strategies
for managing credit risk use traditional credit analysis techniques to screen counterparties and may also take advantage of
hedging via derivatives.
Corporations frequently need to estimate the likelihood of defaults, the exposure, and the severity of loss from a default
event. Taking into account these factors and market-based inputs, it is possible to estimate both expected and unexpected
losses across a portfolio.
Expected credit losses can be statistically estimated over a period of time. Risk-adjusted credit loss provisions can then be
set and factored into pricing as part of the normal cost of doing business. Unexpected losses form the basis for the credit
risk capital-allocation process.
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Instruments
There are three main structures of derivative that enable an organization to manage credit risks more effectively.
With a credit default swap (CDS), a buyer purchases a contract and makes regular payments to a seller of credit protection.
In the event of a default, the buyer receives compensation from the seller. This is commonly seen as an insurance policy for
the buyer. It can, however, be used speculatively as there is no requirement for the buyer to hold any asset or have any
potentially loss-making relationship with the so-called “reference entity.”
Total return swaps are similar to interest rate swaps. One side makes payments based on the total return from an asset. The
other makes floating or fixed payments. The notional amount of the underlying asset is the same for both parties.
A credit linked note (CLN) covers a specific credit risk. Investors receive a higher yield in return for accepting risk relating to
a specific event. It provides a hedge for borrowers against an explicit risk. A CLN is created through a trust using very low-
risk securities as collateral. Investors are paid a floating or fixed rate throughout the period of the note. At its completion they
will either receive par or, if the reference entity has defaulted, the recovery rate value of the note.
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Case Study
Credit Default Swap
Although swaps can be used to hedge against any sort of credit risk, they are easiest to explain through a notional case
study of an instrument such as a bond. A fund may, for example, hold $8,000,000 of Mega Car Company’s five-year bond,
and is concerned about the possibility of default due to market conditions arising from rising oil prices, increased
government regulation on emissions, or the macroeconomic climate.
The fund decides to buy a credit default swap in a notional amount of $8,000,000 to cover the potential default value. The
CDS in this case trades at 150 basis points, so the fund will pay 1.5% of $8,000,000, or $120,000 annually.
If Mega Car Company does not default, the fund will simply receive the full $8,000,000. In this case its return will not be as
good as it would have been without the CDS.
On the other hand, if the corporation does default after, say, two years, the fund will receive its $8,000,000 from the seller of
the CDS. It could be that the seller will take the bond or pay the difference between the recovery value and the par value of
the bond.
Alternatively, Mega Car Company could make a breakthrough in low-emission technology and dramatically improve its credit
profile. In that case the fund might decide to reduce its outgoings by selling the remaining period of the CDS.
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Advantages
Derivatives such as a CDS will reduce or entirely remove the risk of default.
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Disadvantages
The cost of hedging will reduce the return on investment.
Minimizing Credit Riskby Frank J. Fabozzi
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Table of contents
Executive Summary
Introduction
Factors Considered in Assessing Credit Default Risk
Credit Risk Transfer Vehicles
Securitization
Credit Derivatives
Case Study
Conclusion
Making It Happen
Notes
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Executive Summary
Credit risk encompasses credit default risk, credit spread risk, and downgrade risk.
Market participants typically gauge credit default risk in terms of the credit rating assigned by rating agencies.
Factors that are considered in the evaluation of a corporate borrower’s creditworthiness are: the quality of management; the ability of the borrower to satisfy the debt obligation; the level of seniority and the collateral available in a bankruptcy proceeding; and covenants.
Credit risk transfer vehicles allow the redistribution of credit risk.
Securitization is a credit risk transfer vehicle for corporations that is accomplished by selling a pool of loans or receivables to a third-party entity.
Credit derivatives are a form of credit risk transfer vehicle.
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Introduction
Financial corporations and investors face several types of risk. One major risk is credit risk. Despite the fact that market participants typically refer to “credit risk” as if it is one-dimensional, there are actually three forms of this risk: credit default risk, credit spread risk, and downgrade risk.
Credit default risk is the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. This form of credit risk covers counterparty risk in a trade or derivative transaction where the counterparty fails to satisfy its obligation. To gauge credit default risk, investors typically rely on credit ratings. A credit rating is a formal opinion given by a company referred to as a rating agency of the credit default risk faced by investing in a particular issue of debt securities. For long-term debt obligations, a credit rating is a forward-looking assessment of the probability of default and the relative magnitude of the loss should a default occur. For short-term debt obligations, a credit rating is a forward-looking assessment of the probability of default. The nationally recognized rating agencies include Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings.
Credit spread risk is the loss or underperformance of an issue or issues due to an increase in the credit spread. The credit spread is the compensation sought by investors for accepting the credit default risk of an issue or issuer. The credit spread varies with market conditions and the credit rating of the issue or issuer. On the issuer side, credit spread risk is the risk that an issuer’s credit spread will increase when it must come to market to offer bonds, resulting in a higher funding cost.
Downgrade risk is the risk that an issue or issuer will be downgraded, resulting in an increase in the credit spread demanded by the market. Hence, downgrade risk is related to credit spread risk. Occasionally, the ability of an issuer to make interest and principal payments diminishes seriously and unexpectedly because of an unforeseen event. This can include any number of idiosyncratic events that are specific to the corporation or to an industry, including a natural or industrial accident, a regulatory change, a takeover or corporate restructuring, or corporate fraud. This risk is referred to generically as event risk and will result in a downgrading of the issuer by the rating agencies.
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Factors Considered in Assessing Credit Default Risk
The most obvious way to protect against credit risk is to analyze the creditworthiness of the borrower. In performing such an analysis, credit analysts evaluate the factors that affect the business risk of a borrower. These factors can be classified into four general categories—the quality of the borrower; the ability of the borrower to satisfy the debt obligation; the level of seniority and the collateral available in a bankruptcy proceeding; and restrictions imposed on the borrower.
In the case of a corporation, the quality of the borrower involves assessing the firm’s business strategies and management policies. More specifically, a credit analyst will study the corporation’s strategic plan, accounting control systems, and financial philosophy regarding the use of debt. In assigning a credit rating, Moody’s states:
“Although difficult to quantify, management quality is one of the most important factors supporting an issuer’s credit strength. When the unexpected occurs, it is a management’s ability to react appropriately that will sustain the company’s performance.”1
The ability of the borrower to meet its obligations begins with the analysis of the borrower’s financial statements. Commonly used measures of liquidity and debt coverage combined with estimates of future cash flows are calculated and investigated if there are concerns. In addition, the analysis considers industry trends, the borrower’s basic operating and competitive position, sources of liquidity (backup lines of credit), and, if applicable, the regulatory environment. An investigation of industry trends aids a credit analyst in assessing the vulnerability of the firm to economic cycles, the barriers to entry, and the exposure of the company to technological changes. An investigation of the borrower’s various lines of business aids the credit analyst in assessing the firm’s basic operating position.
A credit analyst will look at the position as a creditor in the case of a bankruptcy. The US Bankruptcy Act comprises 15 chapters, each covering a particular type of bankruptcy. Of particular interest here are
Chapter 7, which deals with the liquidation of a company, and Chapter 11, which deals with the reorganization of a company. When a company is liquidated, creditors receive distributions based on the absolute priority rule to the extent that assets are available. The absolute priority rule is the principle that senior creditors are paid in full before junior creditors are paid anything. For secured creditors and unsecured creditors, the absolute priority rule guarantees their seniority to equity holders. However, in the case of a reorganization, the absolute priority rule rarely holds because in practice unsecured creditors do in fact typically receive distributions for the entire amount of their claim and common stockholders may receive something, while secured creditors may receive only a portion of their claim. The reason is that a reorganization requires the approval of all the parties. Consequently, secured creditors are willing to negotiate with both unsecured creditors and stockholders in order to obtain approval of the plan of reorganization.
The restrictions imposed on the borrower (management) that are part of the terms and conditions of the lending or bond agreement are called covenants. Covenants deal with limitations and restrictions on the borrower’s activities. Affirmative covenants call on the debtor to make promises to do certain things. Negative covenants are those that require the borrower not to take certain actions. A violation of any covenant may provide a meaningful early warning alarm, enabling lenders to take positive and corrective action before the situation deteriorates further. Covenants play an important part in minimizing risk to creditors.
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Credit Risk Transfer Vehicles
There are various ways that investors, particularly institutional investors, can reduce their exposure to credit risk. These arrangements are referred to as credit transfer vehicles. It should be borne in mind that an institutional investor may not necessarily want to eliminate credit risk but may want to control it or have an efficient means by which to reduce it. The increasing number of credit risk transfer vehicles has made it easier for financial institutions to reallocate large amounts of credit risk to the nonfinancial sector of the capital markets.
For a bank, the most obvious way to transfer the credit risk of a loan it has originated is to sell it to another party. The bank management’s concern when it sells corporate loans is the potential impairment of its relationship with the corporate borrower. This concern is overcome with the use of syndicated loans, because banks in the syndicate may sell their loan shares in the secondary market by means of either an assignment or a participation. With an assignment, a syndicated loan requires the approval of the obligor; that is not the case with a participation since the payments by the borrower are merely passed through to the purchaser, and therefore the obligor need not know about the sale.
Two credit risk vehicles that have increased in importance since the 1990s are securitization and credit derivatives. It is important to note that the pricing of these credit risk transfer instruments is not an easy task. Pricing becomes even more complicated for lower-quality borrowers and for credits that are backed by a pool of lower-quality assets, as recent events in the capital markets have demonstrated.
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Securitization
Securitization involves the pooling of loans and/or receivables and selling that pool of assets to a third-party, a special purpose vehicle (SPV). By doing so, the risks associated with that pool of assets, such as credit risk, are transferred to the SPV. In turn, the SPV obtains the funds to acquire the pool of assets by selling securities. When the pool of assets consists of consumer receivables or mortgage loans, the securities issued are referred to as asset-backed securities. When the asset pool consists of corporate loans, the securities issued are called collateralized loan obligations.
A major reason why a financial or nonfinancial corporation uses securitization as a fund-raising vehicle is that it may allow a lower funding cost than issuing secured debt. However, another important reason is that securitization is a risk management tool. Although the entity employing securitization retains some of the credit risk associated with the pool of loans (referred to as retained interest), the majority of the credit risk is transferred to the holders of the securities issued by the SPV.
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Credit Derivatives
A financial derivative is a contract designed to transfer some form of risk between two or more parties efficiently. When a financial derivative allows the transfer of credit exposure of an underlying asset or assets between two parties, it is referred to as a credit derivative. More specifically, credit derivatives allow investors either to acquire or to reduce credit risk exposure. Many institutional investors have portfolios that are highly sensitive to changes in the credit spread between a default-free asset and a credit-risky asset, and credit derivatives are an efficient way to manage this exposure. Conversely, other institutional investors may use credit derivatives to target specific credit exposures as a way to enhance portfolio returns. Consequently, the ability to transfer credit risk and return provides a tool for institutional–investors; the potential to improve performance. Moreover, corporate treasurers can use credit derivatives to transfer the risk associated with an increase in credit spreads (i.e., credit spread risk).
Credit derivatives include credit default swaps, asset swaps, total return swaps, credit linked notes, credit spread options, and credit spread forwards. In addition, there are index-type or basket credit products that are sponsored by banks that link the payoff to the investor to a portfolio of credits. Credit derivatives are over-the-counter instruments and are therefore not traded on an organized exchange. Hence, credit derivatives expose an investor to counterparty risk, and this has been the major concern in recent years in view of the credit problems of large banks and dealer firms who are the counterparties.
Credit derivatives also permit banks to transfer credit risk without the need to transfer assets physically. For example, in a collateral loan obligation, a bank can sell a pool of corporate loans to a special purpose vehicle (SPV) in order to reduce its exposure to the corporate borrowers. Alternatively, it can transfer
the credit risk exposure by buying credit protection for the same pool of corporate loans. In this case, the transaction is referred to as a synthetic collateralized loan obligation.
An understanding of credit derivatives is critical even for those who do not want to use them. As Alan Greenspan, then the Chairman of the Federal Reserve Board, in a speech on September 25, 2002, stated:
“The growing prominence of the market for credit derivatives is attributable not only to its ability to disperse risk but also to the information it contributes to enhanced risk management by banks and other financial intermediaries. Credit default swaps, for example, are priced to reflect the probability of net loss from the default of an ever broadening array of borrowers, both financial and non-financial.”2
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Case Study
A credit-linked note (CLN) is a security, usually issued by an investment-grade-rated corporation, that has an interest payment and fixed maturity structure similar to a standard bond. In contrast to a standard bond, the performance of the CLN is linked to the performance of a specified underlying asset or assets as well as that of the issuing entity. There are different ways that a CLN can be credit linked, and we will describe one case here.
British Telecom issued on December 15, 2000, a CLN with a coupon rate of 8.125% maturing on December 15, 2010. The terms of this CLN stated that the coupon rate would increase by 25 basis points for each one-notch rating downgrade of British Telecom below A–/A3 suffered during the life of the CLN. The coupon rate would decrease by 25 basis points for each rating upgrade, with a minimum coupon set at 8.125%. In other words, this CLN allows investors to make a credit play based on this issuer’s credit rating. In fact, in May 2003, British Telecom was downgraded by one rating notch and the coupon rate was increased to 8.375%.
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Conclusion
While market participants typically think of credit risk in terms of the failure of a borrower to make timely interest and principal payments on a debt obligation, this is only one form of credit risk: credit default risk. The other types of credit risk are credit spread risk and downgrade risk. When evaluating the credit default risk of a borrower, credit analysts look at the quality of the borrower, the ability of the borrower to satisfy the debt obligation, the level of seniority and the collateral available in a bankruptcy proceeding, and covenants. Credit risk transfer vehicles include securitization and credit derivatives. Credit derivatives include credit default swaps, asset swaps, total return swaps, credit linked notes, credit spread options, credit spread forwards, and baskets or indexes of credits.
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Making It Happen
Controlling credit risk requires not just an understanding of what credit risk is and the factors that affect a borrower’s credit rating but other important implementation issues. These include:
establishing the credit risk exposure that a corporation or institutional investor is willing to accept;
quantifying the credit risk by using the latest quantitative tools in the field of credit risk modeling;
understanding the various credit risk transfer vehicles that can be employed to control credit risk;
evaluating the merits of different credit risk transfer vehicles to determine which are the most appropriate for altering credit risk exposure.
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Notes
1 Moody’s Investor Service. “Industrial company rating methodology.” Global Credit Research (July 2008): 6.
2 Speech titled “World Finance and Risk Management,” at Lancaster House, London, United Kingdom.
Securitization: Understanding the Risks and Rewards
by Tarun Sabarwal
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Table of contents
Executive Summary
Introduction
Securitization Basics
Benefits of Securitization
Risks of Securitization
Case Study
Conclusion
Making It Happen
Notes
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Executive Summary
Securitization creates value for organizations, investors, and consumers:
It separates the funding of receivables from their origination and servicing, and allows origination and servicing
revenues to grow without additional balance sheet financing.
It provides cash flow and balance sheet management benefits.
It allows for targeted asset liquidation, improvements in asset liquidity, and access to capital markets at rates
different from enterprise credit ratings.
The flexibility in transforming risks permits mutually beneficial matches in targeted market opportunities, both for
organizations and investors.
Deeper capital markets allow for price discovery of illiquid assets, greater access to funds for new firms and
consumers, and greater financial innovation.
Securitization creates risks of moral hazard and lack of transparency:
Separation of funding from origination can create moral hazard, generating higher-than-expected risks and leading
to conflicts between investors, firm shareholders, and firm creditors.
Complexity of structural transformations creates lack of transparency, which, in turn, can lead to greater illiquidity
and possible market failure. These effects are worse in globally inter-connected markets.
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Introduction
In broad terms, securitization can be viewed as pooling receivables and selling claims to these receivables in capital
markets. For example, a mortgage lender may pool together thousands of mortgages and sell claims on mortgage
receivables to investors. Historically, the first securitizations in the 1970s in the United States were those of pools of
mortgages. With the success of mortgage-backed securities, other groups of receivables were securitized as well, including
auto loan receivables, credit card receivables, and home equity receivables.
Although a majority of securitizations are of receivables on consumer debt1 (whether mortgage or nonmortgage), in principle,
any cash flow receivable can potentially be securitized. There are several so-called “exotic” securitizations—for example,
securitization of mutual fund fees, movie revenues, tobacco settlement fees, and even music royalties. Moreover, student
loans, manufactured housing loans, equipment leases, and commercial mortgages are also securitized.
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Securitization Basics
Securitized products have some common characteristics.2 They typically involve an originator of receivables who forms a
pool of receivables that is then sold to a special-purpose entity. This entity in turn issues securities backed by a beneficial
interest in the receivables. For a successful securitization, it is important to understand this process in detail.
The originator of receivables identifies a pool of receivables to be securitized. For example, a mortgage lender identifies
which loans will form a particular pool for a securitization. As borrower and loan characteristics affect receivables and losses
on a loan, the credit quality of the receivable pool is affected by its loan quality.
The originator transfers the receivable pool to a special-purpose entity (SPE), typically a type of trust. Accounting rules
govern the balance sheet treatment of such a transfer. For example, if this transfer is classified as a sale, an originator can
remove these receivables from its balance sheet, but in the case of a financing, it cannot do so. Moreover, for a transfer of
receivables to be a true sale, the ownership of these assets should be separated from the transferor to the extent that in the
case of the transferor’s bankruptcy, the transferor’s creditors should not be able to access these receivables and jeopardize
the beneficial interest of the investors in the securities.3
The SPE issues securities backed by the collateral of receivables in the pool. Different securities (or tranches) issued on the
same collateral pool may have very different risk characteristics, depending on how pool receivables are allocated to
securities and depending on credit enhancements. For example, a senior tranche may have first access to pool receivables
as compared to a junior or subordinate tranche, and therefore, the senior tranche would have a relatively lower risk.
Similarly, a credit enhancement, such as third-party insurance of promised cash flows, lowers the credit risk of the security.
Therefore, depending on the structure of the transaction, securities issued on the same collateral pool may carry different
credit ratings. Over time, securitization structures have evolved in complex ways to take advantage of diverse demands by
investors.4
The differential risks of these securities may change over the life of the securities. For example, credit risk for issued
securities depends on the performance of the underlying collateral pool and on credit enhancements, both of which may
vary over time. Important factors affecting pool performance include a lender’s underwriting criteria (such as credit score of
the borrower, credit history, down payment, loan-to-value ratio, and debt service coverage ratio), economic variables (such
as unemployment, economic slowdown, and bankruptcies), and loan seasoning (payment patterns over the age of loans).
Credit enhancements affect credit risk by providing more or less protection to promised cash flows for a security. Additional
protection can help a security to achieve a higher credit rating, lower protection can help to create new securities with
differently desired risks, and these differential protections can help to place a security on more attractive terms. Violation of
credit enhancements can trigger an “early amortization” event, which starts prepayments on securities using available SPE
resources.
Therefore, pool performance evaluation, security cash flow allocation, and servicing of receivables continue on an ongoing
basis. In particular, bond rating agencies assign a credit rating to each security issued by the SPE, and they evaluate this
rating periodically. Moreover, for publicly issued securities, periodic financial reports are filed with regulatory agencies. The
originator of receivables typically continues to service the receivables (i.e., collect payments on the receivables, manage
delinquent accounts, and so on) for a fee.
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Benefits of Securitization
An important idea behind securitization is that it separates the funding of receivables from their origination and servicing.
Such a separation can provide cash flow and balance sheet management benefits, structural flexibility benefits, and deeper
capital markets.
Cash flow and balance sheet benefits are available to the originator mainly because selling loans in capital markets allows a
lender to raise funds to originate more loans, which can again be securitized. As the originator typically continues to service
the securitized receivables, revenue from origination and servicing activities continues to grow. Moreover, as securitized
assets can typically be removed from the balance sheet, the net balance sheet effect is zero. In this sense, securitization
improves revenues without additional balance sheet financing. A securitization can also improve balance sheet liquidity by
converting long-term and illiquid receivables into funds that can be used for additional value-generating investments. A
securitization can also help to manage any mismatch between assets and liabilities. Finally, to the extent allowable,
selective securitizations of receivables can allow for regulatory capital arbitrage.
Structural benefits from securitization arise from the flexibility available in transforming cash flows and risks of the collateral
pool into those of the securities issued on the pool. For example, creative use of credit enhancements allows relatively poor-
quality receivables, such as subprime loans, to be transformed into some tranches of high credit quality and other tranches
of low credit quality. Similarly, it is possible to carve out long-term, nonrevolving securities from short-term, revolving credit
card receivables.
Structural flexibility allows originators and investors to tailor securitizations to their needs. Originators can sell particular
assets with greater liquidity if these assets can be transformed creatively into securities desired by investors. Similarly,
investors with particular needs may have more choices if different originators innovate to serve their needs.
In principle, deeper capital markets may arise from improved cash flows, better balance sheet management, and greater
structural flexibility. A securitization of high-quality assets may allow a relatively young firm or a firm with a low credit rating
to access capital market funds at lower cost than would otherwise be available. Securitization may facilitate market price
discovery of illiquid assets. It allows for the sale of precisely identified assets to be independent of the asset owner’s
financial condition. It allows greater financial innovation and better matching of sellers and buyers, and it may allow for
deeper debt market penetration by opening newer lending markets, such as subprime lending.
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Risks of Securitization
While the unique characteristics of securitizations are capable of providing benefits, they create additional risks as well.
When standard cash flow risks 5 are combined with the separation of funding of receivables from their origination and
servicing, this may produce unintended consequences. For example, if repayment behavior is significantly worse than
expected, investors may be concerned about moral hazard; that is, receivables in the collateral pool were “cherry-picked,”
and investors may require additional support for the securities. In extreme circumstances, investors may require the
originator to provide an explicit guarantee or to take back poorly performing collateral (sometimes termed moral recourse).
As the collateral pool is off the originator’s balance sheet, recognizing poorly performing assets jeopardizes the originator’s
financial condition, and such actions will be resisted by the originator’s stockholders and bondholders. Similarly, if the
originator is in a poor financial condition, its creditors might consider going after assets that are securitized and off the
originator’s balance sheet. This can jeopardize investor claims on the collateral pool and question the legitimacy of the
bankruptcy-remoteness of the SPE. Moreover, a narrow focus on origination can create an incentive to over-originate (or
overextend) loans to marginally less creditworthy borrowers.
The structural flexibility in transforming collateral pool characteristics into very different security characteristics, while
arguably a great benefit of securitization, also has the potential to create great risks.
The more complex the structure, the greater is lack of transparency, and the harder it is to analyze and forecast security
performance. For example, consider long-term securities collateralized by short-term credit card receivables. These are
naturally exposed to amortization risk due to a mismatch between cash flow receipts on the receivables and cash flow
payments on the securities.6 Add to this a senior-subordinated security structure. Now add third-party insurance, and finally
add subprime credit card receivables, which, because of their recent issue, come with greater uncertainty about their
performance. The riskiness of securities based on such structural transformations depends in a complex manner on many
factors, and a reliable evaluation of that risk may be very hard to obtain, if it can be obtained at all.
Lack of transparency is made worse when the collateral pool in a securitization has opaque or otherwise hard-to-value
assets. As, in principle, any receivable can be securitized, a security that was created as a result of securitization can be
used further in a new collateral pool to issue new securities. As the initial security is hard to analyze, when several such
securities are pooled together and then tranched off again,7 it is not surprising that there are cases where a final security is
inscrutable, even with the most sophisticated analysis.
A complex security, by and of itself, is not an insurmountable obstacle to reap the rewards of securitization. But in uncertain
times, complexity combined with lack of transparency may throw wrenches in the wheels of smoothly operating markets. In
other words, if reliable information is unavailable, market participants may be unwilling to pay high prices for securities that
may turn out to be bad investments, and this can lead to a crisis of confidence severe enough that trade in particular
securities grinds to a halt. Moreover, interconnected debtors and creditors may serve to exacerbate such a problem by
extending it to other securities. Such a dynamic has been mentioned as a core problem resulting in global credit market
disruptions that started in the United States in 2007.
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Case Study
The growth of subprime lending in the United States started around the mid-1990s. A subprime borrower typically has some
combination of a blemished credit history, a relatively short credit history, poorly documented income prospects, and an
uncertain repayment ability.
Before the 1990s, subprime borrowers typically found it hard to qualify for bank loans. During the second half of the 1990s,
in the face of relatively low interest rates, investors were more willing to seek opportunities with higher yields that came with
a greater, but manageable, degree of risk.
Securitization of consumer debt receivables helped to connect these two sides, with finance companies serving as
intermediaries. Improvements in credit reporting and statistical analyses facilitated the development of risk-scoring models to
lend profitably to subprime borrowers. Credit enhancements and structured tranches created securities that addressed
investor needs.
The success of initial securitizations fueled rapid growth in securitizations. Debt markets deepened to provide loans to
subprime borrowers, finance companies found an attractive source of new financing, and could continue to increase
revenues from profitable origination and servicing fees, investors found securities with desirable characteristics, rating
agencies generated additional fees, and third-party insurers generated additional premiums.
In a span of about ten years, concerns started to arise as securitized products became exceedingly complex, with the
introduction of collateralized debt obligations (CDOs), and of CDOs of CDOs, or “CDO-squared;” lending started to look
indiscriminate, with concerns about real estate appraisals, and about lack of adequately documented repayment ability; and
real estate prices appeared to defy historical trends. As the US economy slowed and house prices lowered, and as
delinquencies and foreclosures on subprime debt rose, the value of securities backed by subprime receivables deteriorated.
The complexity and opaqueness of the securitization structures exacerbated the problem by making it virtually impossible to
put a reliable value on these securities. This led to a crisis of confidence that paralyzed trade in some of these securities.
Markdowns in the value of such securities started to hemorrhage balance sheets of security holders, especially some hedge
funds, and led to widespread turmoil on Wall Street, including casualties of large investment banks such as Bears Stearns
and Lehman Brothers in 2008.
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Conclusion
No doubt, securitization presents new developments and exciting opportunities. Securitization allows for more precise
targeting of asset liquidation. It can create value for originators and investors. It can deepen capital markets, thereby
providing funds for new borrowers and new businesses. And it can improve market price discovery for illiquid assets.
When a securitization gets beyond the analytical apparatus of market participants, however, it is capable of destroying
value. The potential harm is greater in globally interconnected markets.
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Making It Happen
Executives may find it useful to keep in mind the following key ingredients to a successful securitization.
Characteristics of assets to be securitized should be documented well and identified clearly.
Transfer of assets to a SPE to form a collateral pool should be a true, bankruptcy-remote sale.
The transformation of collateral pool risks into security risks should be simple enough to provide clear and robust
analysis of the dependence of security risks on collateral performance.
Processes for servicing, and for ongoing monitoring of collateral and security performance, should be well-defined,
with some evidence of success under reliability testing.
Using collateral, securities, and structures with an established history or clear evidence of success provides
greater liquidity in security trading, and more reliable analysis of collateral performance.
Using opaque and exotic structures requires considerable expertise and comes with greater risks.
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Notes
1 Consumer debt is used here in a broad sense, including secured debt (such as home mortgages, auto loans, manufactured
home loans, and so on) and unsecured debt (such as credit cards, student loans, and so on).
2 Although the principles outlined here apply to all securitizations, for concreteness, specifics are presented for consumer
receivable securitizations.
3 This feature is sometimes termed bankruptcy-remoteness.
4 For additional details on some common securitization structures, see Sabarwal, T. “Common structures of asset-backed
securities and their risks.” Corporate Ownership and Control 4:1 (2006): 258–265.
5 Such risks include underwriting risk, interest rate risk, default risk, prepayment risk, and market risk.
6 This is usually addressed by having a revolving period and an accumulation period when cash flow receipts are kept aside
for use later in making promised payments on the securities.
7 Collateralized debt obligations (CDOs) typically have such a structure.
Understanding Free Cash Flow
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Checklist
This checklist defines what free cash flow is and its role in a company’s finances.
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Definition
Free cash flow is a measure of financial performance and is defined as cash flow available for distribution among any parties
that hold security in a company. It comprises the net income plus depreciation and amortization minus capital expenditure
and any changes in working capital. The free cash flow is the cash that a company has available for use after paying out the
necessary expenditure to maintain or expand its asset base. It matters, as it is a means for a company to boost shareholder
value through, for example, mergers and acquisitions, R&D, paying dividends, or reducing debt. It can thus be viewed as an
alternative bottom line.
Unlike earnings, free cash flow represents real cash. It is a very useful way to assess the financial health of a company as it
is what is left after all the accounting assumptions built into the earnings have been stripped away. A company may seem to
be generating high earnings, but only free cash flow indicates whether any real money has been generated in a designated
period. Ultimately, the stock market’s estimate of how much free cash flow a company will generate in the future is reflected
in the share price.
Even a profitable concern may have a negative cash flow. This does not necessarily signal financial problems—it may
indicate that the company is making large investments with potentially high returns. Shareholders may agree to forgo
dividends one year or longer if they believe that such a strategy will produce better returns in the long term.
Free cash flow can, of course, vary from year to year, depending on the capital expenditure (usually referred to as capex)
and any changes in working capital. Thus, no accounting year can be described as normal when measured purely by free
cash flow. However, a company that has stable capex should in the long term have free cash flow that is roughly equal to its
earnings.
It is important to remember that how a company uses its free cash flow matters a lot. A company using its free cash flow on
share buy-backs (for example, when the share price has fallen below its intrinsic value) or to pay out dividends is more
attractive to investors. Conversely, a company that pays out more of its free cash flow in dividends than it is generating is
overstretching its spare cash.
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Advantages
Rising free cash flow often indicates that increased earnings lie ahead. And when free cash flow booms as a result of
revenue growth, cost-cutting, or debt reduction, a company is in a position to reward its investors promptly. This why
analysts generally view free cash flow as a reliable metric for assessing value.
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Disadvantages
Free cash flow is not immune to manipulation in the accounts as there are no regulatory standards for determining it. A
company with a high free cash flow may be underreporting its capex, for example, or stretching out its payments. However,
any impact is likely to be only temporary. Also important to note is that a company may have trouble sustaining earnings
growth if free cash flow is poor, and it may be forced to increase its debt. In the worst-case scenario, insufficient free cash
flow could tip a company into a situation of illiquidity.
Understanding and Accessing Private Equity for Small and Medium Enterprises
by Arne-G. Hostrup
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Table of contents
Executive Summary
Definition of Private Equity
Market Structure and Participants
Investment Process
Case Study
Making It Happen
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Executive Summary
Private equity is an important component of funding for small and medium enterprises (SMEs).
The goal of securing a company’s long-term financing and becoming independent of banks’ continuously changing
lending behavior is one that preoccupies many enterprises, from foundation to sale.
Very few companies are familiar with the market structure, processes, framework, and conditions of private equity.
There are a number of reservations about this type of financing.
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Definition of Private Equity
Private equity is the generic term for all forms of financing through external equity capital in the broader sense. The generic
term is often subdivided into:
Venture capital (VC) is made available by business angels (who provide so-called informal venture capital, or IVC)
and venture capital companies, usually management companies with a venture capital fund under administration. VC is
made use of in a company’s early stages—from foundation, market entry, and growth, right down to bridge financing prior to
an initial public offering (IPO).
Private equity in a narrower sense is made use of in, for example, expansion, internationalization, MBO/MBI,
general reorganization of debt capital financing structures, and turnarounds.
The unequivocal characteristic of private equity in the SME sector is that the investor makes the invested capital available
without provision of security and thus participates fully in the entrepreneurial risk of a business. Capital is normally made
available over the medium to long term (3–10 years) in the form of liable equity. The forms of investment range from
acquisition of a stake under the provisions of company law, with payment of the amount invested into the company’s capital
reserve, to a completely dormant partnership with no direct relationship under the provisions of company law. A combination
of both options is often seen, with the investor becoming a shareholder of the company and making part of his investment as
a nonrepayable payment into the capital reserve and another part as a repayable and continuously interest-bearing dormant
partnership investment.
As regards the extent of the stakes acquired under company law, the range varies from minority and majority holdings to
complete takeovers by the private equity investor. The investor’s objective is to sell the acquired shares at a later point in
time within the framework of a so-called exit, thereby making as much profit as possible. The exit can take place within the
framework of an IPO, a trade sale, or a buy-back by the previous shareholders. Professional private equity investors usually
expect a rate of return of more than 30% per annum. The expectations of business angels may differ.
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Market Structure and Participants
As a basic principle, the private equity market can be subdivided into the informal/formal and private/governmental areas. In
general, the entire field of business angel financing is regarded as the informal private equity market. Business angels are
wealthy private investors who use their own capital to acquire stakes in other companies. The formal private equity market is
the entire “regulated area,” i.e. usually private equity funds or their management companies. Depending on the investment
motive or situation of the company, the market subdivides further, with investors specializing in the following sectors:
seed-financing (business angels);
early-stage businesses;
later-stage businesses;
medium-sized businesses ;
buy-outs ;
corporate venture capital.
Within these sectors there are investors who confine themselves to a certain technology or geographic region. Usually, there
is an umbrella organization that unites the private equity firms in any major country and, in some cases, major regions. As a
rule, umbrella organizations are a good place to find individual investors and to research their respective special interests
(see More Info section).
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Investment Process
Business Plan
A substantive business plan is the basic requirement for any involvement of private equity investors. Within the framework of
the business plan, the company’s strategy and objectives are usually articulated for at least the next five years. In addition,
the firm seeking equity capital must highlight all business and financial aspects of a project. At an international level, the
following structure is commonly found in business plans:
executive summary
product or service
market and competition
marketing and sales
business model , business system and organization
entrepreneurial team, management, personnel
implementation schedule
opportunities and risks
financial planning and financing
appendix.
The business plan is the basis for an investor’s decision to invest and usually becomes an integral part of a participation
agreement. Moreover, the plan is a helpful controlling instrument for management over the following years. The business
plan should therefore be compiled with care.
Selecting and Addressing Investors
How do I find and select the right investor for my company? And how do I address this person or fund? Generally, there are
three ways in which an SME can identify potential investors:
research on the internet, followed by a direct approach with submission of the business plan
presentations at investor conferences
hiring a corporate finance (CF) consultant.
For smaller or younger companies, direct addressing or presentation at conferences is a common method. In particular, this
applies to the entire venture capital segment. Larger or established companies tend to shy away from “publishing” a request
for financing in this way and often make use of a corporate finance consultant. The extent of support provided by such a
consultant ranges from the simple establishment of contact with investors to comprehensive support for the entire process.
For instance, many CF consultants offer support when it comes to compilation of the business plan, then present a list of
suitable investors and take charge of directly addressing such investors. Support during the due diligence process and
contract negotiations is also customary. Consultants are mainly remunerated on the basis of a fixed daily rate (€700–2,000)
and a performance-related fee in the event that a private equity investment materializes. The usual commission ranges from
1 to 4% of the investment. The amount varies depending on the agreed fixed remuneration and the support services
provided.
Due Diligence
After an investor has voiced interest, he or she begins with the due diligence process. The entire company is “put to the
test.” Its history, current market and competition, and strategy for the future are closely examined. Some investors prefer to
undertake parts of the due diligence themselves, but as a rule the task is passed to external consultants. The due diligence
process is often divided into the following parts:
Legal: Fulfillment of the duty to provide information or limitation of liability risks; identification and valuation of legal
risks.
Product/technique: Assessment of products/services at the development stage, technical feasibility, market
acceptance, etc.
Strategic/business: Description and, if possible, quantification of potential on the market and resource side.
Commercial: Assessment of the future development of the market in which the business operates.
Financial: Assessment of the company’s past commercial situation and its future earnings potential.
Tax: Identification of tax-related risks and a tax-optimized design for the transaction.
Environmental: Disclosure of any environment-related liabilities that may impose a heavy cost burden following
conclusion of the deal.
In most cases analysis focuses on the financial and strategic/business areas. Depending on the company’s age and history,
legal due diligence may also become a focal point. The objective is to provide a background for decisions that are in
accordance with the investment, based on the performed corporate analysis. Due diligence requires careful preparation by
the management of the business to ensure that information and data requested by the investor or his agent are properly and
fully presented.
An important factor in preparation and organization of materials for the due diligence process is the selection of a team, and
thereby the establishment of responsibilities for the collection and processing of data and making available contact persons
for interviews.
Before the start of the due diligence process, the company that is going to be scrutinized should create a “data room” in
which all required information is gathered so that it can be accessed and inspected by the examiners. This can range from a
simple folder or CD to a professionally designed online platform (these are offered by specialized service providers). With an
online platform all the required data are input in electronic form so that they can be checked by external examiners with
authorization to access the information. Clearly, the younger a company is, the fewer materials there may be available for
examination. In the case of a foundation project, this material is often confined to the business plan.
Practice has shown that the due diligence process can often become protracted, or that there may even be a breakdown of
the entire contract negotiations, for the following reasons:
incomplete documents;
contact persons not available for interviews;
unconvincing budget planning (e.g. unrealistic assumptions, inconsistent planning, poor or incomplete data
sources);
legal disputes with uncertain outcomes in respect of liability, or warranty and patent risks as well as risks related to
the legal protection of registered designs;
environmental risks;
tax-related risks;
insufficient recoverability/value of inventories and accounts receivable;
management is unable to convince an investor of its ability to realize the business objectives beyond a limited
extent.
Company Valuation
Valuation of the company is almost always the most critical issue in contract negotiations, and intended projects frequently
fail at this particular point as the parties involved are unable to reach agreement on the price. Company valuation can be
based on various internationally recognized procedures, such as:
discounted cash flow ;
multiples like price-earnings ratio or price–cash flow ratio;
asset value procedure;
exit value procedure.
Which procedure is used depends on many factors, such as the preferences of the investor, the country in which the
company’s registered office is located, and the age of the company.
When determining a company value that is appropriate for both sides, the following should be borne in mind:
there is no such thing as a correct value;
although valuation procedures are objectively comprehensible, the range of results they give can be extremely
wide;
company valuation is always a reflection of opinions, which can differ widely—especially with young companies.
However, a valuation can indicate a plausible value;
in the final analysis, it is offer and demand that determine the value of a company.
In conclusion, the general rule is that there is a value, and there is a price.
Contracts
Participation agreements are very extensive contracts, often consisting of several hundred pages. Therefore, a lawyer
should always be consulted. As a general rule, in the case of participation in a limited liability company, such an agreement
has the following components:
participation agreement;
partnership agreement ;
articles of association ;
contract on the establishment of a silent partnership;
advisory committee statute;
management board regulations;
managing director employment contract.
How individual agreements are allocated among the above-mentioned documents may vary from one investor to another.
For instance, certain agreements may be incorporated in the participation agreement by one investor, while another investor
may place the same agreements within the partnership agreement.
Participation agreements include a large number of clauses that often raise problems for companies which are seeking
private equity for the first time. For instance, investors have comprehensive rights to information and codetermination, but, at
the same time, the rights of original shareholders regarding the sale of their corporate shares are massively restricted.
Within the framework of the entire contract negotiations and the composition of the contract, one main thing should be
remembered: Investors and previous shareholders have the same objective—they both wish to make the company as
successful as possible.
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Case Study
InkJet
The German company InkJet Ltd., founded in 2000, has developed an innovative and patented inkjet technology for
industrial use. During the first two years the company focused on development, and in subsequent years it made a
successful entry into the German market. In 2007, with turnover at €4.5 million, InkJet decided to expand its business
internationally, with a focus on the European market as a first step. After drawing up the business plan it was known that
between €2 and €2.5 million would be needed to finance the expansion. Up to that point the company had been entirely
financed by founders’ capital and debt. It was very quickly realized that this method of financing would not work for the
planned internationalization. The company therefore began to seek out a private equity investor, and found one in 2008.
The investor was a corporate venture capital company that focuses on industrial technology, and is backed by an Austrian
enterprise. This company invested €2.5 million in cash. The payment was arranged in three parts, linked to the fulfillment of
three technology and finance milestones (for example, a turnover of €12 million in 2010). The VC obtained 35% of the
corporate shares for €1.3 million. The other €1.2 million was injected as a silent partnership with a current rate of interest of
10% plus an exit kicker. Furthermore, the founders accepted a subsequent adaptation of the company valuation in favor of
the investor if results fall short of the business plan forecasts by more than 10%.
The entire participation process from initial contact to execution of the participation agreements took nine months, of which
the pure due diligence process took approximately four months. The rest of the time was used for internal preliminary
examinations by the investor, contract negotiations, and coordination processes. Technical and commercial due diligence
was carried out by the investor itself, while the tax and legal due diligence was conducted by external consultants.
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Making It Happen
In summary, the following aspects should be taken into consideration before the decision to finance a company with the help
of private equity is executed:
Company’s business model: The business model must be checked as to whether it is suitable for private equity.
Features to look for are high growth potential, sufficient market size, unique selling propositions, customer benefit, and
competitive advantage.
Management team : Complementary talents, professional experience and knowledge of the trade, key positions
filled or capable of being filled over the short term.
Professional business plan: Compilation of the business plan is the prime responsibility of the entrepreneur and his
management team. It is not delegable to consultants, who only have an auxiliary function. The management, especially the
founder, is personally responsible for the business plan’s content, and must “sell” and defend it. Attention must be paid to
the plan’s completeness and formal structure. Beware of exaggerated assumptions with regard to projected sales and
capital requirements.
Select appropriate investors: Look for experience, background, track record, potential for adding value, references
from the portfolio, team structure, age of the fund, financial resources available for new investments, participation
agreements, information, codetermination, and controlling rights.
Contacting: Establishing contact with the selected private equity fund should preferably be done through informal
channels.
Due diligence : The management should use the investor’s check-up to amend the business plan/business model if
required, or to develop it further, and they should be open to criticism and suggestions.
Cooperation: Management should do their utmost to support the due diligence process in an open and honest
manner, tell the truth, and submit suitable references. They should not conceal anything from the investor, as he will be the
future copartner, able to make the founder personally liable for years to come based on the liability provisions of the
participation agreement.
If a memorandum of understanding is reached: Negotiations about company valuation shouldn’t start too early:
“The longer they check, the hotter they become, the more they are willing to pay”! Founders should not attempt to play off
investors against each other, as the various private equity players in any one country usually know each other personally.
Consultants: The advisability of calling in legal and tax consultants to conduct contract negotiations is self-evident.
Any money saved by not doing so may well be completely negated by consequent losses or expenses incurred at the exit
stage.
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Back to Table of contents
Further reading Current tab: Websites:
Websites:
African Venture Capital Association: www.avcanet.com
Association Française des Investisseurs en Capital (France): www.afic.asso.fr
Australian Private Equity and Venture Capital Association: www.avcal.com.au
British Private Equity and Venture Capital Association: www.bvca.co.uk
China Venture Capital Association: www.cvca.com.hk
European Private Equity and Venture Capital Association: www.evca.eu
German Private Equity and Venture Capital Association: www.bvkap.de
Indian Venture Capital Association: www.indiavca.org
National Venture Capital Association (US): www.nvca.org
Due Dilligence on Private Equity Funds
Executive Summary
Private equity fund due diligence is the first step in an investment process. The goal of due diligence is to identify
the risk–return profile of a fund offer.
A well-structured due diligence process contains a top-down macro and a bottom-up manager analysis, allowing
the investor to filter the most promising funds.
A consistent framework for fund and fund-manager assessment is essential. This assessment must address
quantitative and qualitative aspects, and focus on the manager’s “ingredients for success”.
At first sight, fund offerings may appear attractive from a pure return perspective. It is crucial that the investment
has an attractive risk–return balance.
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Introduction
The term “due diligence” covers a broad range of different due diligence types. These can be grouped into three major
types; financial, legal/tax, and business due diligence. The goal of this article is to shed light on business due diligence for
investing in private equity funds. Due diligence is commonly defined as “the process of investigation and evaluation,
performed by investors, into the details of a potential investment, such as an examination of operations and management,
the verification of material facts”.1 “It is a requirement for prudent investors and the basis for better investment decisions.”2
Private equity fund evaluation faces specific challenges; the private character of the industry makes it inherently difficult to
obtain the relevant information; furthermore, the investment decision reflects a commitment to a fund manager to finance
future investments rather than a straightforward purchase of specific assets. Therefore, common evaluation techniques used
to assess public equity investments are not appropriate within the private equity asset class.
The private equity market has enjoyed extraordinary growth rates in the past, and private equity investments showed strong
returns, supported by a booming economy and an expanding debt market. The current financial crisis will have a significant
impact on the private equity market; a shake-out of fund managers is to be expected over the coming years. Managers who
can demonstrate how they created value in the past, beyond just benefiting from favorable market developments, and who
are able to make a compelling case for future value creation will continue to raise capital successfully.
Before investing in a private equity fund, an investor should have sufficient comfort regarding:
Strategy perspective: the investment strategy of the fund.
Return perspective: evidence that the manager stands out compared to his/her peer group.
Risk perspective: assurance that risk is mitigated to the level required by the investor.
The relative youth of the private equity industry, data paucity, as well as benchmarking difficulties within and across asset
classes are just a few elements that indicate why the investor has to rely on qualitative aspects and judgment during the due
diligence process of private equity funds.
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Structural Set-Up of a Due Diligence Process
The Overall Framework
A solid due diligence framework contains a top-down review as a first step. This review must assess the attractiveness of
the various private equity sub-segments and regions. The assessment includes various evaluation criteria, such as
investment opportunities in the segment, capital demand and supply, the quality of the fund manager universe, entry and
exit prices, and the future development potential of the sub-segments. Furthermore, it is important that the investment
strategy of a fund manager is not only attractive on a stand-alone basis, but also within the overall context of the investor’s
total portfolio.
Generating a complete overview of the relevant fund manager universe is the second step. Worldwide, there are about
3,000 private equity fund managers to be considered, making the creation of this overview a very demanding task. It is
crucial not to assess the managers who provide you with their fund offering passively, but proactively to benchmark all
relevant fund managers for a proper peer-group comparison.
The third step of the framework is to ensure that risks related to the potential commitment are mitigated through an in-depth
due diligence process. For all identified issues, due diligence steps must be taken in order to clarify the situation. An
investment should only be considered if a sufficient level of comfort is achieved on all issues.
Example of a Due Diligence Process
A clear, well-structured due diligence process, which is tailored to the context of the fund manager, with concrete steps and
tools, is an important prerequisite for a comprehensive and consistent fund-manager evaluation. Below, we describe a
process structure that is the result of continuous improvements over the past 25 years.
Figure 1. Example of a proven due diligence process structure
The first screening of the fund offering addresses the track record, strategy, team, and fit with the portfolio. This analysis can
be performed by junior professionals, but it is important to have an experienced senior professional reviewing the screening
and taking the final decision whether to conduct further due diligence. This ensures that the senior has the full picture of the
deal flow and the market dynamics.
The prequalification phase starts with a detailed portfolio analysis of all past investments made by the fund manager.
Interactions with the fund manager are used to clarify the impact on the value contribution of the manager to past and future
investments. Putting these insights into a structured risk–return framework (see next section detailed below), combined with
peer-group benchmarking, allows the identification of fund offerings with a promising risk–return potential. It is beneficial
broadly to discuss fund offerings within the investment team to identify critical aspects, residual risks, and external
referencing possibilities. This knowledge exchange defines questions for the qualification phase.
The qualification phase is divided into four steps:
1. Dual control: the project worker starts working with an independent devil’s advocate. The goal of this step is to
identify all potential weaknesses that could be discovered by a pair of fresh eyes, and to ensure the quality of the process. It
also helps specify further tailored action steps that need to be addressed, and to clarify open issues.
2. The second step is to review the fund manager’s governance structures and processes, with the goal of identifying
operational and team dynamic risks.
3. The third step is the verification of the self-assessment through third-party referencing. Well-prepared reference
calls with past and present key people from underlying companies are an extremely helpful resource for verifying your
current impression of the fund manager. Reference calls provide the opportunity to check the contribution of the fund
manager to the value creation and the investment sourcing. If external referencing confirms the current assessment and
does not lead to new questions, the investment opportunity fulfils all three evaluation levels: appealing strategy, return
potential, and controlled risk.
4. The last step is the legal and tax due diligence.
The investment decision and subscription: having a formalized investment approval mechanism, for example through an
investment committee, rounds off the due diligence process, which, as a last step, includes the subscription process to the
fund.
Thorough monitoring must be put in place once a long-term investment is made. Monitoring is needed to ensure that active
measures can be taken where needed, in order to maximize value for the investor. Monitoring is also an integral part of the
due diligence for the investment decision regarding the fund manager’s next fund (typically after three to four years). Due
diligence represents a deep monitoring effort on prior fund investments.
Risk–Return Framework
A clear fund-manager evaluation framework provides consistency among different manager evaluations, and allows for
proper benchmarking of managers within a specific peer group. A scoring system that is appropriate for the qualitative and
quantitative analyses on a fund manager has proven useful. By constantly applying the system, the scoring becomes well
calibrated. Furthermore, it allows for best-practice manager benchmarking across geographies and segments. Due to the
qualitative nature of private equity, the focus of the assessment must be on the “ingredients for success” within the future
competitive landscape.
In order to enable the ranking of fund managers within a peer group, a quantitative benchmarking that looks at the return
and risk aspects helps to put the full due diligence findings into an aggregate picture. We have applied the following
framework during the past decade.
Table 1. Framework for a manager evaluation addressing risk and return aspects with a scoring system
Return assessment criteria Score Risk assessment criteria Score
Historical performance
Quality of past performance
Aggregate deal performance over time
X.XX Historical performance Quality of past performance
Deal by deal volatility
X.XX
Deal sourcing Quality of deal flow
Involvement in deal origination
X.XX Operations/team risk Governance structure
Process quality
X.XX
Value creation Operational competence
Level of active involvement in deals
X.XX Investment strategy risk Investment discipline
General risk elements
X.XX
Exit capacity Track based on many deals vs. single hit
Corporate buyers network
X.XX Aggregate company financing risk Milestone vs. upfront financing
Quality of syndication partners
X.XX
Portfolio return considerations Common characteristics of individual
companies supporting return potential
X.XX Portfolio return considerations Common characteristics of individual
companies supporting risk potential
X.XX
Total return score X.XX Total return score X.XX
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Case Study
Fund Due Diligence for the MCAP Fund3
MCAP is a newly formed, European, first-time fund manager launching a €250 million fund specialized in development
capital and small buyout investments in a single industry. The key person for the fund has deep industry experience. He
successfully founded and grew a company operationally superior to more mature, competitive companies. Subsequently, the
company was acquired by an international corporation, where he then became the CEO. After stepping down, he formed
MCAP. Besides him, there are two other partners who also left their high caliber jobs to launch MCAP. The additional team
members previously worked together in various positions; however, none of them has a track record as an investment
professional.
A standard due diligence process focused mainly on the historic performance of the fund would pass on this fund after the
first screening. The risk–return framework has a different approach:
The industry targeted by the fund is not covered by existing fund managers. The industry appears to be attractive
for backing small, flexible, and dynamic companies with high technological and operational excellence. MCAP could,
therefore, be a promising complementary investment.
The fund manager’s ingredients for success from a deal-sourcing and value-creation perspective are in place
through the extensive networks of MCAP’s partners, and their in-depth industry expertise. Exit capability has only been
proven in the sale to the international corporation; there is neither a proven track record, nor an established competitor.
Nevertheless, the risk–return assessment framework can be applied to benchmark this new fund against other funds with a
single industry focus. Reference calls are important sources for validating the reputation and the competency of MCP’s
team.
Risk mitigation for the investor is the most challenging aspect of the due diligence in this case. The management
firm is in formation, and the concept is to operate like an industry holding company, managing five investments with deep
operational involvement. It is evident that the fund operation will be loss-making, and that the partners are pre-financing this
initiative substantially. They are well aligned with the investors in the fund. Close interaction with the manager, and legal
terms allowing intervention by investors, should MCAP drift off course, are prerequisites for reaching the level of comfort
needed to make a fund commitment.
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Conclusion
Private equity fund due diligence is a work-intensive undertaking. It requires a clear top-down assessment of investment
segments and geographies that, based on fundamental drivers, appear attractive for investment. For the bottom-up fund
manager evaluation, a proper due diligence process with clear milestones must be established. This process must be
supported by tools that allow a structured assessment of a fund offering, and ensure comparability of different funds. When
working in a broad team, special attention is also needed to make certain that all professionals apply the same framework,
and that evaluations by different people lead to comparable results.
Finally, it must be emphasized that, while there appear to be many promising investment opportunities, the most important
element for due diligence is to identify the risk behind each opportunity.
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Making It Happen
The foundation of a successful due diligence process is a structured process, a proven evaluation framework, and an
experienced team. Some valuable aspects are:
In-depth knowledge of past fund investments, their business and investment performance, and the fund manager’s
value creation is crucial for the evaluation and the understanding of a private equity fund’s offering.
Broad sharing of the investment project work among all investment team members ensures the quality of the due
diligence process, and a consistent investment philosophy across the firm.
Well-prepared reference calls provide an excellent perspective on how a fund manager creates value.
An experienced senior professional acting as devil’s advocate on an investment project provides valuable, internal
challenging and risk mitigation.
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Notes
1 Sood, Varun. “Investment strategies in private equity.” Journal of Private Equity 6:3 (Summer 2003): 45–47. Online at:
dx.doi.org/10.3905/jpe.2003.320050
2 Mayer and Mathonet, 2005.
3 Fictitious fund example, based on actual cases.
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Understanding Private Equity Strategies: An Overview
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Checklist Description
This checklist outlines the primary strategies used in private-equity investment.
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Definition
Private equity firms generally want to buy companies or parts of companies for their portfolios, repair them, enhance them,
and sell them on. The investment period is seldom less than a year and can be as long as 10 years, but the objective is
always to sell the business on at a substantial profit. Private equity investors have three main investment strategies:
1. Venture capital is a broad class of private equity that normally refers to equity investments in less mature
companies. Venture capital is often subdivided according to the phase of maturity of the company, ranging from capital used
for the launch of start-up companies to later-stage and growth capital. It is often used to fund the expansion of an existing
business that is generating revenue but may not yet be profitable or generating sufficient cash flow to fund future
investment.
2. Growth capital refers to equity investments (most often minority investments) in more mature companies that are
looking for capital to expand or restructure operations, enter new markets, or finance a major acquisition without a change in
the control of the business.
3. The leveraged buyout (LBO) is a strategy of equity investment whereby a company, business unit, or business
asset is acquired from the current shareholders, typically with the use of financial leverage. The companies involved in these
buyouts are generally more mature and generate cash flows.
Occasionally, investments are made in distressed or special situations, where the equity or debt securities of a distressed
company are unlocked as a result of a one-off opening, such as market turmoil or changes in financial regulations.
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Advantages
Private equity can provide high returns, with the best private equity investments significantly outperforming the
public markets. The potential benefits for successful investors can be annual returns of up to 30%.
An important perceived advantage of private equity is that the agency problem is reduced, because the owners
have direct contact with the managers and can do detailed monitoring.
Because private equity firms focus on just a few investments, their due diligence is much more solid (and costly)
than that of the investor in a public company.
Not only is a far larger share of executive pay tied to the performance of the business, but top managers may also
be required to put a major chunk of their own money into the deal and have an ownership mentality rather than a corporate
mentality.
With LBOs, management can focus on getting the company right without having to worry about shareholders.
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Disadvantages
Most private equity investments have significant entry requirements, stipulating a considerable initial investment
(normally upwards of $1,000,000), which can be drawn upon at the manager’s discretion.
Private equity investment is for those who can afford to have their capital locked in for long periods of time and
who are able to risk losing it.
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Action Checklist
Bankers are much more wary of leveraged financing nowadays, and they should be included at the beginning of
the planning, as well as during the negotiation stages.
Carefully analyze any business you might be proposing to acquire. Does its portfolio fit the characteristics required
to mount an LBO? Can you revamp it, enhance it, and sell it? What time-frame will you be looking at?
Use specialist financial researchers and advisers. Remember that any undiscovered potential liabilities might cost
more in the long run.
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Dos and Don’ts
Do
In the primary stages, involve your lawyers and accountants in the evaluation of both the risks and the potential
benefits of an acquisition.
When the company has been acquired, use incentives to engage the onboard key business managers in helping
with the turnaround process.
Involve key stakeholders, and spell out in clear terms the risks the organization may be facing, their probability,
and their potential impact, whether positive or negative.
Don’t
Don’t put the cart before the horse and make the mistake of being drawn to a business that has not been
thoroughly investigated. Consider not only whether it can be turned around, but also whether you can get the financing
Options for Raising Finance
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This checklist outlines options for raising finance.
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Definition
Funding small and medium-sized enterprises is a major part of the general business finance market. When a budding
company is growing rapidly and needs to invest in capital equipment or other assets, its financial capital may be insufficient.
Few emerging companies are able to finance their expansion plans from cash flow alone. Therefore, entrepreneurs need to
consider raising finance from external sources. Once they have decided to raise capital, they need to consider what source
and type of finance will suit their needs.
Venture capital : Is intended for higher risks, such as start up situations and development capital for established
companies.
Joint venture : Find an individual or organization to both invest in and work with a company in its business project.
Limited company: Raise capital by setting up a limited company and selling shares to investors.
Banks for working capital: Short-term finance or the working capital necessary to fund the day-to-day running of
the business. This can take the form of an agreed overdraft, where the interest will be calculated on your daily outstanding
balance and charged on a monthly or quarterly basis.
Banks for medium-term loans: A loan paid back over an agreed term (typically three to ten years), where
principal and interest are paid off monthly. This type of loan is used mainly to invest in equipment, expansion, and
development.
Banks for long-term loans: The most common way to arrange long-term borrowing. This type of loan is normally
used to purchase assets such as a business, land, buildings, plant, or machinery that can be shown to directly or indirectly
add to profit over a number of years.
Factoring and invoice discounting: To improve cash flow, finance can also be raised against customer debts
using factoring or invoice discounting.
Leasing: Provides finance for the acquisition of specific assets, such as cars, equipment, and machinery. Leasing
involves a deposit and repayments over, typically, three to ten years. The financier purchases the equipment you require
and then leases it to you in return for regular payments for the duration of the lease period.
Personal loans : If it is impossible to arrange a loan in your business’s name, you could consider arranging a
personal loan. However, check that the conditions do not jeopardize control of the business and that you are very confident
of being able to repay or you may lose the assets put up as collateral.
Family and friends: To avoid any misunderstandings and/or resolve any dispute if things go wrong, it is
imperative to make a written agreement, including the timescale and interest payments.
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Advantages
Finding the finance on the right terms allows small and medium-sized enterprises to invest in land, new capital
equipment, R&D, etc. Very few emergent companies are able to finance their expansion plans from cash flow alone.
Raising finance helps to avoid the dilution of business control or share capital.
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Disadvantages
Venture capitalists normally want preference shares or loan stock in addition to their equity stake.
Joint ventures and the setting up of limited companies can often result in the loss of control over aspects such as
policy and development.
Banks have the power to place a business into administration or bankruptcy if it defaults on debt interest or
repayments.
Borrowing from family or friends can lead to disputes or interference in the management of the venture.
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Action Checklist
Prepare a written business plan explaining in detail your business objectives, your operating plan, projected
earnings, marketing strategy, and other relevant information.
Use the strategy laid out in the business plan to help you assess all the alternatives and then negotiate terms with
several financial providers before choosing the one that suits you best.
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Dos and Don’ts
Do
Consider what source and type of finance suits your needs. Then match the method of funding and the term of the
loan to the reason for the finance.
Don’t
Don’t forget that your financing decisions may have an impact on business cash flow and taxation obligations.
Private Investments in Public Equity
by William K. Sjostrom, Jr
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Table of contents
Executive Summary
Types of PIPE
Registration Requirement
PIPE Issuers
Investors in PIPEs
Making It Happen
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Executive Summary
A private investment in public equity (PIPE) is a type of public company financing transaction that is prevalent in
the United States.
In a typical PIPE transaction, a public company privately issues common stock or securities convertible into
common stock to a small number of sophisticated investors in exchange for cash. The company then registers the resale of
the common stock issued in the private placement, or issued on conversion of the convertible securities issued in the private
placement (the PIPE shares), with the US Securities and Exchange Commission (SEC).
Generally, investors must hold securities issued in a private placement for at least six months. However, because
the company registers the resale of the PIPE shares, investors are free to sell them into the market as soon as the SEC
declares the resale registration statement effective (typically at most within a few months of the closing of the private
placement).
In 2009, companies closed on 1,072 PIPE deals in the United States, raising approximately $36.7 billion in the
aggregate.
While companies of all sizes have used PIPEs to raise money, PIPE deals have emerged as a vital source of
financing for small public companies, with the overwhelming majority of deals being completed by companies with market
capitalizations of $250 million or less. This is driven by the reality that PIPEs represent the only available financing option for
many small public companies.
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Types of PIPE
PIPE transactions are highly negotiable; hence, there is a fair amount of variation from deal to deal with respect to the
attributes of the PIPE securities. PIPE securities may consist of common stock or securities convertible into common stock,
such as convertible preferred stock or convertible notes, and may be coupled with common stock warrants.
Regardless of the type of securities involved, PIPE deals are categorized as either traditional or structured. With a traditional
PIPE, the PIPE shares are issued at a price fixed on the closing date of the private placement. This fixed price is typically
set at a discount to the trailing average of the market price of the issuer’s common stock for some period of days prior to
closing of the private placement. As mentioned above, securities regulations generally prohibit investors from selling PIPE
shares prior to the SEC declaring the resale registration statement effective. Thus, because the deal price is fixed, investors
in traditional PIPEs assume price risk, which is the risk of future declines in the market price of the issuer’s common stock
during the pendency of the resale registration statement.
With a structured PIPE, the issuance price of the PIPE shares is not fixed on the closing date of the private placement.
Instead, it adjusts (often, downward only) based on future price movements of the issuer’s common stock. For example,
investors may be issued convertible debt or preferred stock that is convertible into common stock based on a floating or
variable conversion price, i.e., the conversion price fluctuates with the market price of the issuer’s common stock. Hence,
with a structured PIPE, investors do not assume price risk during the pendency of the resale registration statement. If the
market price declines, so too does the conversion price, and therefore the PIPE securities will be convertible into a greater
number of shares of common stock.
For example, say an investor purchases a $1,000,000 convertible note in a PIPE transaction, and the note provides that the
principal amount is convertible at the holder’s option into the issuer’s common stock at a conversion rate of 90% of the per
share market price of the stock on the date of conversion. Thus, if the market price of the issuer’s common stock is $10 per
share, the note is convertible at $9.00 a share into 111,111 shares of common stock. If the market price drops to $8 per
share, the note is then convertible at $7.20 per share into 138,889 shares of common stock. Regardless of how low the price
drops, on conversion the investor will receive $1,000,000 of common stock based on the discounted market price of the
stock on the day of conversion.
Some structured PIPEs do contain floors on how low the conversion price can adjust downward, or caps on how many
shares can be issued on conversion. If a structured PIPE has neither a floor nor a cap, it can potentially become convertible
into a controlling stake of the PIPE issuer. Continuing the example from above, if the market price dropped to $0.01, the
note would then be convertible into more than 100 million shares, which would constitute a controlling stake unless the
issuer had at least 200 million shares outstanding. Hence, structured PIPEs lacking floors or caps are pejoratively labeled
“death spirals” or “toxic converts,” because investors in these deals may be tempted to push down the issuer’s stock price
through short sales, circulating false negative rumors, etc., so that their structured PIPEs become convertible into a
controlling stake of the issuer.
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Registration Requirement
The registration requirement of a PIPE transaction can be either concurrent or trailing. With a concurrent registration
requirement, investors commit to buy a specified dollar amount of PIPE securities in the private placement, but their
obligations to fund are conditional on the SEC indicating that it is prepared to declare the resale registration statement
effective. If the SEC never gets to this point, the investors do not have to go forward with the deal. Thus, the issuer bears the
registration risk; that is, the risk that the SEC will refuse to declare the resale registration statement effective.
With a trailing registration rights requirement, the parties close on the private placement and then the issuer files a
registration statement. Consequently, the investors bear the registration risk. If the issuer never files, or the SEC never
declares the registration statement effective, the investors will not be able to sell their PIPE shares into the market for at
least six months. As a result, PIPE deals that include such trailing registration requirements typically obligate the issuer to
file the registration statement within 30 days of the private placement closing date and require that it be declared effective
within 90 to 120 days of such date. If these deadlines are not met, the issuer is obligated to pay the investors a penalty of
1% to 2% of the deal proceeds per month until filing or effectiveness.
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PIPE Issuers
As mentioned above, companies of all sizes have used PIPEs to raise money. Larger companies pursue PIPEs as a quicker
and cheaper route to funding than a registered public offering. The vast majority of PIPE deals, however, are undertaken by
small public companies. These companies generally pursue PIPEs not because they offer advantages over other financing
alternatives, but because the companies have no other financing alternatives. By and large, PIPE issuers are not only small
in terms of market capitalization but have weak cash flow and poorly performing stocks. Thus, traditional forms of financing
are simply not an option. Few, if any, investment banking firms are willing to underwrite follow-on offerings for small,
distressed public companies. Further, these companies lack the collateral and financial performance to qualify for bank
loans and the upside potential to attract traditional private equity financing.
Given the distressed status of PIPE issuers, PIPE financing can, of course, be very expensive. Not only does the company
typically issue common stock or common stock equivalents at a discount to market price, but PIPE deals often involve other
cash flow rights such as dividends or interest (typically paid in kind not cash) and warrants. For example, in August of 2007,
Callisto Pharmaceuticals, Inc., a biopharmaceutical company located in New York, raised $11.2 million in a PIPE financing
consisting of 1,124,550 shares of Series B Convertible Preferred Stock, and 22,491,000 warrants. The conversion price of
the Series B Preferred Stock was set at a 23% discount to Callisto’s market price on the day prior to the deal. This compares
to a typical discount of 4% for a traditional seasoned equity public offering.
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Investors in PIPEs
Hedge funds constitute a large percentage of the investors in micro-cap PIPEs. Hedge funds invest for the obvious reason:
their returns from PIPE investments meet or beat market benchmarks. Hedge funds are able to obtain market-beating
returns notwithstanding the poor performance of PIPE issuers through a relatively straightforward trading strategy. They sell
short the issuer’s common stock promptly after the PIPE deal is publicly disclosed. To execute a short sale, a fund borrows
stock of the PIPE issuer from a broker–dealer and sells this borrowed stock into the market. The fund then closes out or
covers the short sale at a later date by buying shares in the open market and delivering them to the lender. By shorting stock
against the PIPE shares, the fund locks in the PIPE deal purchase discount. With a traditional PIPE, if the market price of
the issuer’s common stock drops below the discounted price following a PIPE transaction, the fund will take a loss on the
PIPE shares, but this loss will be exceeded by gains realized when it closes out its short position because it will be able to
buy shares in the market to cover the position at a lower price than it earlier sold the borrowed shares. If the market price of
the issuer’s common stock rises after the PIPE transaction, the fund will take a loss when closing out the short position,
because it will have to buy shares to cover the position at a higher price than it earlier sold the borrowed shares. This loss,
however, will be exceeded by an increase in the value of the PIPE shares since they were purchased at a discount to the
pre-rise market price.
In addition to short selling, many hedge funds retain up-side potential by negotiating for warrants as part of a PIPE
transaction. Hedge funds typically hold on to these warrants even after unwinding their PIPE shares positions so that they
can profit further in the event the issuer’s stock happens to rise above the warrant exercise price. In sum, hedge funds are
able to garner superior returns through PIPE investments because they purchase the PIPE shares at a substantial discount
to market, manage their downside risk through short sales and floating conversion prices, retain up-side potential through
warrants, and liquidate their positions a relatively short time after closing on the private placement.
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Making It Happen
Explore other financing options first; PIPE financing is often very expensive, especially for smaller public
companies.
Retain experienced PIPE counsel (see the league tables at www.sagientresearch.com PIPE agents).
Retain a PIPE agent to advise on deal structure and locate investors (see the league tables mentioned above.
If pursuing a structured PIPE deal, insist on a floor on how low the conversion price can adjust downward, or a cap
on how many shares can be issued on conversion.
Consider restricting investors’ ability to engage in short selling.
Consider the amount of dilution existing investors will suffer as a result of the PIPE financing and how to address
their complaints.
Make sure you consult your accountant because, depending on structure, the deal may produce a noncash charge
to earnings
Merchant Banks: Their Structure and Function
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Checklist Description
This checklist describes merchant banks, what they do, and who can make use of their services.
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Definition
Merchant banks, also known as investment banks, offer various services in international finance and long-term loans for
wealthy individuals, multinational corporations, and governments.
An investment bank is split into the so-called front, middle, and back office functions. The front office deals with investment
banking and management, sales and trading, structured products, private equity investment, research, and strategy. The
middle office deals with risk management, finance, and compliance. The back office deals with transactions, operations, and
technology.
The main function of a merchant bank is to buy and sell financial products. They manage risk through proprietary trading,
carried out by special traders who do not interface with clients. The trader manages the risk for the principal after they buy or
sell a product to a client but does not hedge their total exposure. Banks also try to maximize the profitability of certain risk on
their balance sheets.
Merchant banks manage debt and equity offerings. They assist companies in raising funds from the market. This can include
designing instruments, pricing issues, registering offer documents, underwriting support, issue marketing, allotment and
refund, and stock exchange listing. They also help in distributing securities such as equity shares, mutual fund products,
debt instruments, insurance products, and fixed deposits among others. Merchant banks use a mix of institutional networks
—mutual funds, foreign institutional investors, pension funds, private equity funds, and financial institutions—and retail
networks, depending on how they interact with specific clients.
Merchant banks offer corporate advisery services to clients for their financial problems. Advice may be sought in such areas
as determining the right debt-to-equity ratio, the gearing ratio, and the appropriate capital structure. Other areas of advice
may be in areas of refinancing and seeking sources of cheaper funds, risk management, and hedging strategies. Further
areas for advice are rehabilitation and turnaround management. Merchant bankers may design a revival package in
conjunction with other financial institutions.
Merchant bankers assist clients with project advice, helping them from the project concept stage, through feasibility studies
to examine a project’s viability, to the preparation of documents such as a detailed project report.
Merchant banks arrange loan syndication for their clients. This begins with an analysis of the client’s cash flow patterns,
helping to determine the terms for borrowing. The merchant bank then prepares a detailed loan memorandum to be
circulated to the banks and financial institutions that are to join the syndicate. Finally, the terms of lending are negotiated for
the final allocation.
Merchant banks provide venture capital and mezzanine financing (a hybrid of debt and equity financing that is typically used
to finance the expansion of existing companies). In this way they can help companies to finance new and innovative
ventures.
Following the global financial crisis of 2008, which saw the collapse of several prominent investment banks in Europe and
the United States in September of that year, the viability of using a business model that is based heavily on banks
purchasing each others’ debts has been severely questioned. Certainly in the United States, the view is that this business
model is no longer sustainable and is unlikely to continue in the same form in the future. It remains to be seen how merchant
banks will restructure in the aftermath of the financial turbulence of 2008.
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Advantages
Merchant banks perform functions that cannot be carried out by businesses on their own.
Merchant banks have access to traders, financial institutions, and markets that companies or individuals could not
possibly reach.
By using their skills and contacts, merchant banks can get the best possible deals for their clients.
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Disadvantages
Merchant banks are really only for large corporate customers, or extremely wealthy smaller businesses owned by
individual clients.
Not all deals carried out by merchant banks meet with unqualified success.
There is always risk attached to the kinds of deal that merchant banks undertake.
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Action Checklist
Shop around for a merchant bank.
Understand what the bank is offering and make clear exactly what you expect it to do.
Make sure that the results are fully monitored and reported back to you.
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Dos and Dont’s
Do
Use a merchant bank with good standing and history.
Use a merchant bank with a firm financial footing—especially in times of uncertainty about financial institutions.
Don’t
Don’t use a merchant bank if you are a small business.
Don’t use the first merchant bank you find.
Don’t go in blindly without understanding the risks involved.
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Further reading Current tab: Books:
Books:
Chapman, Stanley. The Rise of Merchant Banking. Economic History Series. London: Routledge, 2005.
Young, George Kennedy. Merchant Banking: Practice and Prospects. 2nd ed. London: Weidenfeld & Nicholson,
1971
Understanding and Calculating RORAC, RAROC, and RARORAC
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This checklist explains the differences between RORAC, RAROC, and RARORAC, and describes how to calculate and use
them.
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Definition
RORAC is the return on risk-adjusted capital. (Risk-adjusted capital is capital that has been adjusted after balancing the five
main risk metrics—alpha, beta, r-squared, standard deviation, and the Sharpe ratio—against each other so that return can
be calculated on a level playing field.) It should not be confused with RAROC, which is risk-adjusted return on capital, and its
close cousin, RARORAC, risk-adjusted return on risk-adjusted capital. The capital that is being invested, or risked, is usually
called economic capital.
RORAC is generally used to evaluate projects or investments that have a high element of risk for the capital involved. The
RORAC formula (RORAC = Net income / Allocated economic capital) allows comparison of investments that have different
levels of risk or different risk profiles. Here, the economic capital is adjusted for the maximum potential loss after calculating
probable returns and/or their volatility. It is a very useful method of quantifying and managing acceptable levels of exposure
to risk. Note that RORAC is used when the risk may vary according to capital assets used—it is the capital itself that is
adjusted for those risks, rather than the rate of return.
RAROC is a method for measuring risk-based profitability that also enables a consistent comparison of the risky financial
returns of a range of projects or investments. It is usually defined as the ratio of risk-adjusted return to the economic capital.
Rather than adjust the risk of the capital (as in RORAC), it is the risk of the return itself that is adjusted and measured. One
of two formulae may be used: RAROC = Expected return / Economic capital, or RAROC = Expected return / Value at risk.
Using capital based on risk improves the capital allocation across any scenario in which capital is risked for a return
expected to be above the risk-free rate.
RARORAC is increasingly used as a measure to assess both the risk-adjusted economic capital and the risk-adjusted return
on an investment. It uses the capital adequacy guidelines as defined by Basel II. It is calculated by dividing the risk-adjusted
return by the economic capital after including the diversification benefits.
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Advantages
These ratios allow for the incorporation of market risk, credit risk, and operational risk within a single
comprehensive framework that shows the interrelationships between different sorts of risk and scenarios where there might
be a too-high concentration of risks.
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Disadvantages
These ratios cannot cover systemic risks, which still need to be calculated separately.
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Action Checklist
Make sure you develop a risk-conscious compensation structure. By considering RORAC, rather than
conventional, accounting-based, profit-and-loss calculations, it is possible to compensate managers for minimizing risk and
maximizing return. Including RORAC in a company’s compensation structure gives risk management authority, encourages
responsible, longer-term decision making, and discourages the short-term “quarterly profits” mentality.
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Dos and Don’ts
Do
Use these ratios to make informed decisions on the value of investments or projects and to create long-term
strategies that bear risk in mind.
Consider their use as part of the discipline of building a comprehensive risk management strategy.
Don’t
Don’t forget that these ratios are flexible enough to apply as a metric to business models, cash flow projections,
and other corporate financial conventions, as a means of integrating risk management from diverse areas
